Why And How Long Bond Yields Matter To Equities
Notwithstanding Tuesday’s move, long bond yields are up over 100 basis points since their 2017 lows. Are rising long bond yields bad for share prices? It all depends on growth, on which we remain constructive. While we answer the how and why questions here under, in summary, we think the growth cycle in India is turning and a front-ended rise in bond yields is good news for equities. The risks to equities are that bonds offer better value than equities at current levels and/or inflation undergoes a supply shock from higher fiscal spending, rising oil prices and/or higher food prices.
Why, The Easy Question
When valuing equities, investors add the equity risk premium they seek to a risk-free rate to compute the expected rate of return.
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. It is a matter of debate whether government long bonds are really risk-free, but that is beyond the scope of this note, and whether the discount rate for future dividends should have anything to do with long bond yields – again this debate is not the objective of this essay.
How, The More Difficult Question
Based on this premise (that the long bond yield is the risk-free rate) higher bond yields are bad for equities and vice versa. However, in practice that is not how it works. The correlation between equities and bonds is a function of why bond yields are changing and not just the direction of change.
When valuing equities, the risk-free rate constitutes the denominator, but the reasons why the risk-free rate goes up or down influences the numerator, i.e., the cash flows investors receive from equities.
Long bond yields 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. When growth is strong, the salutary impact of higher growth on the numerator (cash flows or, more precisely, dividends) more than offsets the negative impact of the rise in the discount factor (due to higher yields) causing equity share prices to trade higher. Put another way, the confidence in the future is high, and equities are rewarded with higher multiples. The opposite is the case when bond yields are rising despite sluggish growth, i.e., due to inflation worries.
The gap between real gross domestic product growth and the 10-year bond yield correlate well with share prices underpinning the point made above. Indeed, to the extent that growth accelerates in the coming months faster than the rise in bond yields, share prices should be fine (assuming everything else remains constant – a simple assumption by any standards).
Equities/bond relative valuation is at the top end of its 2010-18 range – a period during which India went through its deepest and longest earnings recession.
If growth accelerates from here, it is likely that equities will break this range on the upside, consistent with the fundamental relationship between bonds and equities as explained earlier. If it doesn’t (not our base case), equities will continue to lose ground relative to bonds.
Ridham Desai is managing director at Morgan Stanley India and also serves as head of equity research and India equity strategist.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.