Mumbai: Investors are now facing a challenge in capital allocation as yields in India on 10-year bonds have reached 6.21%, the highest since August, while yields on US Treasuries of the same maturity hit one-year high of 1.61%. That is causing the dilemma: Bonds or stocks?
The differential between the earnings yield on equities and bond yields has improved since the beginning of the year, and is currently at 3.3% compared to 2.8% on Jan 1. Historical data suggest that when the yield spread increases, the market goes up and if the gap narrows, equities consolidate. Hence, analysts are not too concerned about rising bond yields in the US and India.
“Generally, the equity market turns volatile in the initial phase of a reversal in bond yields. However, going by the past trends, the equity market tends to eventually stabilise and do well in a rising bond yield environment as the upside in the bond yield is driven by improving economic growth outlook,” said Gaurav Dua, SVP, head-capital market strategy, Sharekhan. “The strong revival in economy and expected healthy growth in corporate earnings would support valuations.”
In March 2020, the yield spread between the equity and bond markets fell below 1% and the market corrected more than 24% in March alone. The yield spread gap narrowed in November-December of 2014 and the Nifty return was -4% in 2015. Between 2010 and 2013, the gap continued to decline, and the stock market was in a consolidation phase. However, the gap widened to over 3% in early 2014 and there was a sharp rally in the stock market. Again, the spreads bottomed in November 2016 and Nifty rallied nearly 40% in the next one year. Similar was the case in 2005 and 2007.
“There is no risk to equity markets, although bonds are offering better value as the growth cycle is turning,” said Binod Modi, head-strategy, Reliance Securities. “While higher crude price and bond yields may be a near-term challenge for India, the ongoing rebound in corporate earnings is likely to sustain and any meaningful correction in the market should be used to buy quality stocks.”
Satheesh Krishnamurthy, head of third party products, Axis Bank, said historically the stock market corrected when interest rates go up. “However, the improvement in earnings is likely to offset the increase in interest rates. There is money waiting to be deployed and FII flows have also been very strong.”