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Moneycontrol Pro Panorama | Red-hot Yield: What Can Calm The Markets’ Nerves?

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Rising US bond yields have shaken world markets, including India. The US 10-year yield is at a new post-pandemic high of 1.87 percent. Even the 2-year yield, which was trading at 0.5 percent at the start of December, has gone above 1 percent to close at 1.04 percent.

US markets fell sharply on Tuesday, with the S&P 500 losing 1.8 percent and the Nasdaq dropped by 2.6 percent. The spillover effect was seen in Asian markets, with all of them trading in different shades of red.

Incidentally, India’s 10-year government bond yield increased to a 23-month high of around 6.6 percent.

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So, what is it about bond yield that spooks equity markets?

There are various ways in which a rising yield impacts the market. In the US, a higher 10-year yield impacts mortgage rates and is considered as a barometer for investor confidence.

On a fundamental basis, looking at the event through the lens of a fund manager, the bond yields cast a deeper shadow on equity markets, as they represent the opportunity cost of investing in equities. Investing in equities will be attractive only if the expected return surpasses the risk-free returns of the bond market at the least. Generally, as a rule of thumb, there is a risk premium of around 5 percent that is added above the bond yield. But this risk premium also fluctuates, depending on several factors, foremost among which is liquidity.

If the bond yield is at 6.5 percent, a savvy investor would be interested in betting on the market if it is likely to return more than 11.5 percent, when the risk premium is 5 percent. The higher the bond yield, the higher will be the return expectation from the equity market. Thus, equity markets will have to correct in a higher bond yield scenario to make them attractive.

Another way of looking at the same issue is by comparing bond yields with earning yields. Earning yields are nothing but earnings per share divided by the price of the share or the inverse of the P/E ratio. A stock is attractive only if the earnings yield is higher than the bond yield. Else, it makes little sense to invest in a risky asset like equity.

If we look at the same issue from the valuation point of view, bonds are normally used as the risk-free rate when calculating the cost of capital. Higher bond yields would mean higher cost of capital. When an analyst uses this bond yield in his future cash flows table, he will need to discount future earnings at a higher rate. This will reduce the valuations of stocks.

At the operational level, a higher cost of funds would mean companies will have to pay more for their borrowed funds, thus leaving less money to percolate down to the profit level.

It is these reasons that cause foreign funds to sell their equity investments and move to bonds.

In the US, the upward journey of bond yields seems to have just started. Analysts expect anywhere between 4-5 rate hikes in 2022 as compared to three advocated by the Fed in its earlier meetings. Yields are expected to touch 2.25 percent by September irrespective of the impact of Omicron or its upgrades.

That being the case, there are strong reasons for equity markets to move down. What could save the day is higher growth and earnings. But can economies grow strongly when central banks and governments are no longer providing a boost?

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