Should you be worried about rising bond yields?

Bond yields have moderated lately, with the benchmark 10-year Indian government bond dropping below 6 per cent, given concerns regarding India’s near-term growth trajectory and the RBI buying government securities under the new G-SAP (G-sec Acquisition Programme) programme. However, rising global inflationary pressures amid recovering global GDP growth have raised the probability of a possible withdrawal of ultra-loose monetary policy, which is likely to drive bond yields higher. Benign domestic and global liquidity have been a key support for equity market performance. Thus, it is important to understand what impact rising bond yields would have on equity markets.

Why bond yields matter

Before going into that question, it is imperative to understand why bond yields matter for equities. While valuing equities, investors add an equity risk premium over a risk-free rate to figure out an expected rate of return. The widest used estimate for risk-free rate, is the country’s long government bond yield or the 10-year government bond yield. According to conventional wisdom, a rise in bond yields should be negative for equity prices, given (i) higher bond yields will make investing in bonds more attractive relative to equities and (ii) a higher discount rate could lower the value of future earnings and cash flow, thus hurting stock prices.

However, the correlation between bond and equities is more of a function of why bond yields are changing rather than just the direction of change. Bond yields reflect the growth and inflation mix of an economy. When growth is strong, bond yields would usually rise, reflecting an improving environment. Similarly, bond yields rise in an inflationary environment. However, the impact of the above two situations is very different for equities. When growth is strong, the improvement in cash flows and future earnings more than offsets the negative impact of the rise in the discount factor on account of higher yields, impacting equity share prices positively overall. But, when bond yields rise despite sluggish growth (i.e. because of inflation worries), equity prices are impacted negatively.

History rhymes

While history may not repeat itself, it often rhymes. A glance at the relationship between bond yields and equities shows that historically, while equities have experienced brief bouts of volatility when bond yields have risen significantly, rising yields have also been accompanied by rising equity markets. Looking back at history (since 2000), the Indian equity market has a high probability (about 80 per cent) of strong positive returns when bond yields rose sharply (above 75 bps) (see table).

For example, during the period October 2003 to November 2004, when the benchmark bond yield went up by more than 200 per cent, equity markets too posted positive returns, with large- and mid-cap segments delivering 26 per cent and 49 per cent respectively.

The few instances of bond yields and equity prices having negative correlation, i.e., the bond yield went up and the equity market went down, were during the 2008 global financial crises (GFC) and for a brief period in 2005. Even during periods of stagnant growth (2010-11 Euro debt crises) or high inflation (2013-14 taper tantrum), equities eked out marginal positive returns.

Further, looking at sectoral performance, we find that cyclical and value-oriented sectors (Banks, Capital Goods, Information Technology and Materials) tend to do better than growth-oriented sectors (FMCG, Auto, Healthcare) in these situations. For instance, during the same period as mentioned in the previous example, banks (up 31 per cent), capital goods (43 per cent) and IT (62 per cent) sectors delivered higher returns than FMCG (12 per cent) and healthcare (21 per cent). Also, mid-cap equities have delivered higher returns on average over large-cap equities during such periods.

What next for equities

Since April 2021, the Covid (second) wave has accelerated rapidly with lockdowns intensifying across the country. Though the sharp second wave is likely to hit India’s recovery in the near term, India’s medium-term growth prospects remain strong, given favourable base effects, expectations of the second wave peaking and flattening between end-Q1 and early Q2, faster vaccination roll-out and fiscal support. Further, with the RBI’s primary focus on supporting a sustainable recovery in growth, monetary policy remains supportive.

Overall, though in the near term bond yields could be range-bound, over the medium term bond yields are likely to trend higher, albeit slowly. In our view, Indian bond yields rising from low levels of 2020 is likely to be viewed as a sign of improving growth expectations and confidence in the economy with macro fundamentals robust amid a still healthy earnings outlook. In sum, the environment of gradually rising bond yields from very low levels should be a positive for equities and cyclical and value sectors.

The author is Chief Investment Strategist, Standard Chartered Wealth, India