Why smart equity investors track bond markets

Equity investors need to keep a track of the bond markets to avoid getting caught on the wrong foot during the upturns and downturns in the stock market. Here are the reasons why…

Most of the investors in the stock market tend to ignore the bond market. No doubt, stocks and bonds are two different investment instruments with varying degrees of risks and rewards. The stock market is much more volatile than the bond market. Therefore, the risks and rewards for investment in stocks is much higher than investments in bonds. So, these equity investors assume that there is no correlation between the stock market and the bond market.

But they are mistaken. The rise or fall in the yields of bonds can impact the equity markets. The bond and the equity markets have an inverse relationship. This is because a sharp rise in the bond yields can lead to a fall in the stock markets, and vice versa.

But before we understand the relationship between bond market and the equity market, let us understand the bond market first. When we talk about bond market, we are referring to the trading of the government bonds. Bonds are also issued by state governments, municipalities and large corporates. The government raises money through the sale of bonds for specific projects or for other development purposes.

But that is not the only purpose of issuing bonds. Through the bond market, the Central  government can influence interest rates, inflation and the economy in general. Let us understand how this is done.

In a scenario of rising inflation, the central bank, that is, Reserve Bank of India, raises the repo rate in order to contain inflation. A rise in repo rate means that the interest rates of commercial banks go up. The higher interest rates are then reflected in the higher yields on bonds in the bond market. The cost of capital of the companies goes up due to higher interest rates on their borrowings. As a result, the profitability of the companies can take a hit due to the increase in interest cost. The adverse impact on profitability would be reflected in the downward movement in the stock prices. Therefore, higher cost of capital depresses the valuation of equities as it impacts future cash flows of the company.

When the inflation is moderate, the government may wish to give impetus to growth. So, the RBI may reduce repo rates gradually over a period of time. The lower repo rates will be reflected in the falling bond yields and lower lending rates of banks. The reduced interest rates will bring down the interest cost of the companies. This will lead to higher profitability for the companies and higher level of investments in industrial and services sectors. Thus, falling bond yields may signal a bull run for the stock markets.

The bond yields in a way provide an objective parameter for calculating the opportunity cost of investing in equities. So, for example, if the 10-year Government of India bond offers a yield of 7%, it would be worth investing in equities only if the dividend yield on stocks is higher than 7%. But that’s not all. Since equities are riskier than bonds, there will have to be a risk premium for investing in equities. So, if we assume the risk premium for equities to be 3%, it will make sense to invest in equities only if the minimum yield from equities is 10% (7%+3%). Therefore, the yield of 10% would be the opportunity cost of investing in equities.

The rise or fall in bond yields impact the inflow of investors’ money from the bond market to the equity market, and vice versa. When the interest rates are on the rise, the yield offered by the bond market may tend to go up to the level of the yield offered by the equities or even exceed it. In which case, retail and institutional (both domestic and foreign) investors may be tempted to move their money from equities to the comparatively safer avenue of the bonds. This is because an equivalent or higher yield offered by bonds comes at a lower risk as compared to equities. The outflow of money from the equity market to the bond market can cool an overheated stock market or can even lead to a crash in the equity market if the outflow is heavy.

The opposite will be true in the case of falling interest rates. When interest rates fall, the yields on bonds will be lower as compared to the yield on equities. This will prompt investors to move their funds from bonds to equities to earn higher returns, albeit at higher risk. The outflow of money from the bond market to the equity market can lead to a bull run in the equity market.

So, when does the money move out or move into the stock market? Money moves into the stock market when the yield offered by bonds is lower than the dividend yield offered by the stocks. This usually happens when the stock market reaches bottom and investing in high dividend yield stocks makes better sense than remaining invested in bonds offering lower yields.

As against this, when the stock market reaches its peak, money will flow out of the stock market and get parked in bonds. This is because at higher valuations, the dividend yield on stocks will be much lower than the yield offered by bonds. Therefore, stock market investors will book profit at peak levels and invest the funds in bonds as the yields offered by bonds will be much higher than dividend yield on stocks.

As an equity investor, you now know why you need to keep a track of the bond market. So, follow the movement of the bond market and be a smart investor.

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