What are Bonds and Bond Yield?
When you buy a bond, it's like you're lending money to the people who created the bond. They promise to pay you interest for as long as you own it. The bond's yield tells you how much money you can expect to make from it, similar to earning interest on a loan.
A bond yield is the yearly money you get from owning a bond, like earning interest. It has a special link with the stock market. When bond yields go up or down, the stock market often does the opposite. This is true not just in India but around the world. Understanding this relationship can help investors decide when to buy or sell stocks.
For instance, a bond with a face value of ₹1,000 promises to pay 10% interest annually, and the current bond price is ₹1,200.
The following formulas can help you calculate the Annual coupon payment and the Bond Yield amount:
Annual coupon payment = Face value * Interest rate
In this case, the annual coupon payment will be: ₹1,000*10% = ₹100
Bond yield = Annual Coupon Payment/Current Bond Price
₹100/₹1,200 = ₹0.0833 or 8.33%
The bondholder would receive an interest of 8.33% at the current price.
Bond Yield: Relation to the Stock Market
It's interesting that bond yields really affect stock prices. Generally, when bond yields go down, stocks do really well, and when bond yields go up, stocks don't do as great. This pattern might not be obvious in the short term, but if you look over a long period, it's pretty clear. So, if you check a long-term chart, you'll see this relationship between bond yields and the stock market.
The above chart shows how the 10-year US Government bond yield and the S&P 500 index are related. Over the past few years since late 2021, the 10-year bond yield has increased in April 2022, while the S&P 500 has gone down. This means that the usual opposite trends between bond yields and the stock market have weakened lately. As bond yields have gone up, people find bonds a better and safer option than stocks.
Bond Yield: The Relationship Between Bond Yields and Equity Valuations
Bond yields are the key to calculating the opportunity cost (next best alternative) of equities. If a 10-year bond gives you a 9% return each year, stocks need to offer more than that to be worth the risk. Let's say stocks need an extra 6% return to make up for their higher risk, making it 14% in total.
If stocks don't offer at least a 14% return, they're not worth investing in compared to bonds. When bond yields rise, stocks need to offer even higher returns to be attractive, which is one reason why bond yields and stock prices often move in opposite directions.
Bond Yield: Impact on the Cost of Capital in Valuing Equities
This relationship is really important and has a big impact. When people want to figure out how much a stock is worth, they often compare it to the safest way they could invest their money, which is usually government bonds. The interest rate from these bonds is considered a "safe bet," and it helps to understand if a stock is a good deal or not. When bond yields go up, the cost of getting money also goes up. This means that future profits are worth less. So, stock values go down. This is why when interest rates are cut, stocks usually do better. Lower rates mean stocks are seen as more valuable because they're discounted less in terms of cost.
Bond Yield: Impact on Foreign Institutional Flows in India
In recent times, there has been an interesting trend. When bond yields rise in the US, foreign investors find bonds more appealing compared to bonds in other countries. This causes them to move money out of stocks and into bonds. Lately, we've seen foreign investors pulling money out of Indian stocks and tend to invest in US bonds as the interest rate is high/bond yield is high.
Bond Yield: Impact on Companies
Bond yields play a significant role in the bond-stock relationship. When bond yields rise, companies need to pay more interest on their debt. This makes it harder for them to manage their debt, increasing the chance of bankruptcy, especially for smaller companies with lots of debt. Analysts and investors often use bond yields as a key signal to predict where stocks might be heading.