When bond yields go up, as they have gone up in the last 1 year, the impact is not just on the bond markets. Of course, your bond portfolio and your bond fund NAVs dot take a hit. But did you know that a rise in interest rates also hits the equity markets? Here is why.
There is a pressure on valuations if you look at DCF valuations
One may wonder how bond yields will impact equity valuations. That is because bond yield impact the cost of debt. The cost of debt is one of the components of cost of capital. That means; when the bond yields go up, the cost of capital goes up. But why does that matter? Let us go back to how equities are valued. The future cash flows of the company are projected and then they are discounted back to present value. When you value the company as a whole, the cash flows are discounted by the average cost of capital (average cost of equity + average cost of debt). Now things become a lot clearer. If the bond yields go up then the average cost of debt goes up and so the average cost of capital also goes up. Effectively, the future cash flows will be discounted at a higher rate and when the denominator goes up the value of the company will go down. That explains why equity markets tend to get jittery when the interest rates in the market starts moving up.
If debt yields are higher, then equity will ask for still higher yields
Do you know the cost of equity? No it is not the dividends. That means a company that does not pay dividends has zero cost of equity. That is obviously not the case. Cost of equity is the return that equity shareholders expect from the company. What returns do equity investors expect? An investor who invests in government bonds is happy with low returns as the money is safe from default risk. When you invest in equities you want to be compensated for a variety of other risks that you take on. Here is how the risk matrix looks like.
Firstly, equity investor at least needs to earn the risk-free rate on a government bond. That is the base case scenario. Secondly, investors need to earn at least what the passive index (Nifty or Sensex) can earn. Why do I take the trouble of stock selection if I cannot even beat the index? Thirdly, the investor will need compensation for systematic risk as measured by Beta. For example, a company with a Beta of 1.20 will require more compensation than the index. Finally, I will also need compensation for risks that are unique to the company or the industry in which the company is operating. When the bond yields go up then the risk free rate of return (Rf) goes up and hence equity investors will demand higher returns. If they are not able to earn higher returns, the stock price will correct downward to adjust the yield to higher levels. This is also called the earnings yield approach.
Smart investors may prefer bonds over equities
If bond yields trend higher and equity earnings yields don’t match up then investors will find it more lucrative to be invested in debt rather than in equities. Why should I invest in equities and take all the risk if I am not compensated. As well stick to debt! For example if the P/E is 25, that means the earnings yield (E/P) is 4%. If bonds are giving a current yield of 7%, then long term investors will have an incentive to prefer bonds and debt instruments over equity. The debt paper is so much more attractive than equity that it just does not make sense to stay invested in equities. Smart money will flow out of equities and into bonds.
Higher bond yields means higher borrowing cost and so more financial risk
In the current scenario, the bond yields on 10-year benchmark bonds have gone up to 8.20%. If the government, which is the bluest of blue chips, is raising funds at 8.20% then private sector will have to pay a higher rate to raise funds. Today, even blue chips are facing higher borrowing costs and that means the problem could be a lot more acute for mid cap and small cap companies with lesser financial muscle. Higher borrowing costs could put a strain on the financial viability of companies. Higher interest cost will mean lower interest coverage and that is an indicator of higher financial risk. Companies will find it increasingly difficult to meet their debt servicing out of their cash flows and start relying on rolling over their debt.
There is also an institutional angle to it. Banks and mutual funds holding bonds in their portfolios will face investment depreciation due to higher bond yields. To that extent, their NAVs will reduce and that will reflect in returns. But not all is negative about rising interest rates. The economy requires competitive rates so that lenders are adequately rewarded. The only positive feature is that in the longer run equities have gained from higher yields if it is supported by GDP growth. Of course, the only condition is that there is no runaway rise in interest rates like what we are seeing in countries like Turkey and Argentina. That is the challenge!
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