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Let's talk about how rising bond yield in US resulted massive global stock market crash.
On Friday, 26 Feb 2021, the S&P BSE Sensex settled 1,939.32 points at 49,099.99 -- its worst one-day fall since May 4 last year, just because the US 10-year Treasury yield jumped more than 16 basis points to 1.614%, its highest level since February 2020? A gradual rise in bond yields globally has created a panic in the equity markets? How?
The big question arises here is How 10 Bond yields affects the stock market?
What is 10-Year U.S. Treasury Yield and Why it matters?
Treasury bond yields (or rates) are tracked by investors for many reasons. The yields are paid by the U.S. government as interest for borrowing money via selling the bond. Because they are backed by the U.S. government, Treasury securities are seen as a safer investment relative to stocks. The 10-year yield is used as a proxy for mortgage rates. It's also seen as a sign of investor sentiment about the economy. When confidence is high, prices for the 10-year drops and yields rise. This is because investors feel they can find higher returning investments elsewhere and do not feel they need to play it safe. But when confidence is low, bond prices rise and yields fall, as there is more demand for this safe investment.
At the global level, US Treasury yields surged to their highest since the pandemic began on expectations of a strong economic expansion and related inflation.
Just like US, In India also, the 10-year government bond yield jumped to 6.18%. The benchmark bond (10-year tenor) yields had fallen to 5.6% during the peak of the pandemic crisis but have since been rising and jumped 31 bps since the Budget. Year to date, the yields have crept up 16 bps in 2021 so far.
How 10 Bond yields affects the stock market?
When valuing equities, investors add the equity risk premium they seek to a risk-free rate to compute the expected rate of return. For example, If you are getting 6% in bonds and 10% in equities then your equity risk premium is 4%. Usually the easiest way to estimate the risk-free rate is to default it to the long government bond yield. This is why long bond yields matter to equities. Now, theoretically, given that the long bond yield is the risk-free rate, a higher bond yield, decreases the equity risk premium, which is bad for equities and vice versa.
Bond prices and yields move in opposite directions—falling prices boost yields, while rising prices lower yields.
Here are the three ways Bond yields affects the stock market:
1) Return on Investment:
Bonds are simply loans that the lenders gives to a corporation or government. The lender receives the principal at the end of the loan tenure if the borrower doesn't default. Bond yield is the return that an investor gets on that bond/loan or on a particular government security.
Lower interest rates put upward pressure on stock prices for two reasons. First, bond buyers receive a lower interest rate and less return on their investments. It forces them to consider buying higher-risk stocks to get a better return. Second, lower interest rates make borrowing less expensive. It helps companies who want to expand. It assists homebuyers to afford larger houses. It also helps consumers who desire cars, furniture, and more education. As a result, low-interest rates boost economic growth. They lead to higher corporate earnings and higher stock prices.
Read more: Opening an Account with RBI for Investing?
2) cost of capital:
Traditionally, when bond yields go up (means higher returns in bonds), investors start reallocating investments away from equities and into bonds, as they are much safer. As bond yields rise, the opportunity cost of investing in equities goes up, and equities become less attractive. Also, a rise in bond yields raises the cost of capital for companies, which in turn compresses the valuations of their stocks. That is something that investors see when RBI cuts or raises the repo rate. A cut in the repo rate reduces the cost of borrowing for companies, leading to a rise in share prices, and vice versa.
3) FPI outflow:
Bond yields play a big role in FPI flow. A higher return on treasury bonds in the US leads investors to move their asset allocation from more risky emerging market equities or debt to the US Treasury, which is the safest investment instrument. So, a continued rise in yields in developed markets puts more pressure on Indian equity markets, which may witness an outflow of funds. Even a rise in domestic bond yields would see allocation moving from equity to debt.
If RBI decides to increase interest rates, the bond's price (which is offering similar return as the current interest rates) would fall because its coupon payment is less attractive now on a relative basis. Therefore, investors would chase new bonds with better risk-free return. A rally in the stock market tends to raise yields as money moves from the relative safer investment bet to riskier equities. However, if the inflationary pressures begin to look up, investors tend to move back to bond markets and dump equities.
Please note, Long bond yields also reflect the growth and inflation mix in the economy. If growth is strong, bond yields are usually rising. They also rise when inflation is going higher. The impact of these two situations is different for equities. A powerful economic rebound combined with rising interest rates and higher inflation, if that indeed transpires, will change the investment backdrop in a meaningful way. If the US Fed remains committed to keeping short-term yields low, that will give people comfort we will not get a ‘taper tantrum,’ where rates suddenly skyrocket.
What is taper tantrum?
will cover in next article :)
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