Factor 8- Bond Yields
Next factor that affects the stock market are ‘Bond Yields.’
Bonds are investment securities issued by corporations and governments for the purposes of raising money. Bonds can be of many types such as zero-coupon bonds, perpetual bonds, floating-rate bonds, fixed-rate bonds, subordinated bonds, bearer bonds, etc.
The Coupon Rate on the bond is the annual interest payment made by the issuer on the Face Value of the investment. This number is usually used as a reference for the risk-free rate of interest in the economy. The Yield on the bond is the internal rate of return (IRR) when an investor holds the bond till maturity.
Now, let us see a few differences between Yield & Coupon:
- The Yield is the rate of return that a bond generates, whereas a coupon is the rate of interest that a bond pays annually.
- Yield = annual coupon payment/ market value of a bond & Coupon rate = coupon payment/Face Value of the bond
- The Yield defines how much an investor will be paid in the future & a coupon tells us what the bond paid when it was issued.
- Yield changes with the change in the bond's market price, whereas coupon rates remain fixed for the entire duration of a bond.
There exists an inverse relationship between bond yields and bond prices. When the price of a bond increases, its yields fall and vice-versa.
You can deep dive into other crucial aspects of the bond market in our Debt Markets Module on ELM School.
Bond Markets have a huge spill over effect on the Equity Markets. This is because bonds compete with stocks for the same money. If an investor observes that he can get a decent return just by investing at the risk-free rate of interest, he would move some of his money out of stocks and use them to purchase bonds.
For instance, if government bonds yield 6%, equity market returns need to be way above 6% to compensate for the additional risk- an equity risk premium of say 4%. This means that the investor must only risk his moolah in equities if he expects returns to be north of 10%.
Simply put, as bond yields go up the opportunity cost of investing in equities goes up & makes it a less attractive option.
Hardening of yields might also point to an increase in the consensus estimate for expected inflation as investors demand additional returns for the loss in the real value terms. Surging bond yields have the potential to threaten a nascent economic revival as the Central Bank may be forced to announce rate hikes to keep a lid on inflation. Such a step would predominantly signify that it is time to bid goodbye to cheap money. Quite naturally, higher Interest Rates would deter governments and corporations from borrowing more in the future. An already existing floating-rate borrowing would only add to the trouble.
Bond Yields in developed markets like The USA, United Kingdom, Germany, Switzerland tremendously affects the fortunes of equities in emerging markets. An increase in the bond yields back home sends shivers down the spine of Foreign Investors as they face the double whammy of a stronger Greenback (fall in real returns as the local currency has depreciated) & higher borrowing costs in their home country.
Some historical periods might point to the conclusion that the correlation between the returns on stocks & bonds is positive, others that it is negative. We believe that these variations can be a signal of fundamental change in the broader market environment. However, it has been observed in the past few years, that the correlation between the two i.e., stocks and bond returns move in opposite directions.
Although trading of debt instruments has not picked up pace in India yet, Boutique investment banks have a separate fixed-income division hosting scores of traders who trade anything & everything from government bonds, corporate bonds, gilts, credit derivatives, mortgage-backed securities, money-market instruments, etc. The scale of operations is massive and so are the opportunities.