How are Bond Yields and Stock Markets Related to Each Other?

Stock market India is a market that allows investors to buy and sell stocks. There are two types of stocks, equity, and debt. Equity stocks are those that have a claim on the company's assets, while debt stocks have a claim on the company's liabilities. 

Anybody can become an investor in stock markets by buying shares of a company's stock or by investing in an index fund that tracks a basket of stocks based on their size, value, and other factors. Investors can use various means like cash deposits and bank loans to purchase stocks on exchanges.

Time and again a movement in bond yields has impacted the stock markets. More often than not, the two move in opposite directions. The impact and the relationship can be witnessed across borders as well. Bond yields are the interest rates paid by bonds. They refer to the amount of money a bond pays out to its holder as interest each year.

The higher the yield, the higher is the amount of money you get back from your investment in bonds. If you have invested in a bond with a lower yield, you will receive less money than if you had invested in one with a higher yield.

What is a Bond and Bond Yields?

If you purchase a bond, it means you are lending money to the bond issuers. The bond issuers have agreed to pay you interest during the lifetime of the bond. The bond yield is an indicator of how much money you will earn from a bond or other debt instrument (like a loan).

The higher the bond yield, the higher your return on investment will be. If you have a low bond yield, you could end up paying a lot more in interest than if you had a high bond yield. That's why it's important to know how much money you'll earn before investing too much money into something like this. 

Yield is the effective rate of return you receive on maturity after selling the bond. When the yield is calculated beforehand, it is assumed that the bond is held till maturity.

A bond also pays you an annual return known as coupon payments which are mostly fixed. Bond yields and bond prices are inversely related to each other. When bond yields rise, the price of existing bonds goes down. This is because higher yields make the new bond more attractive than the older bonds offering lower yields.

How Do Bonds Affect The Stock Market

1) Bond Yields And Cost Of Capital

The cost of capital (COP) is the rate of return required by a company to cover its opportunity cost of borrowing money. It measures how much investors are willing to pay for the risk that the investment will yield less than expected. The higher the risk, the lower the return investors require and vice versa.

Bond yields are a key factor in determining the cost of capital for companies and investors. Corporate bond yields are determined by the interest rates that governments pay on bonds, which are typically higher than the interest rates paid on government securities.

Since most bonds have fixed interest rates and do not adjust based on inflation, they suffer from what is known as "negative real yield," meaning they lose value over time.

However, bond yields can also be affected by changes in other factors, such as prevailing interest rates or stock market volatility. When bond yields fall below their original nominal value, this indicates that investors have less faith in their ability to make money with those investments.

This is often referred to as "contagion" because it spreads across all types of bonds and affects all levels of investors in different ways.

2) Opportunity Cost

If bond yields go up high enough to beat the returns from stocks, the opportunity cost of investing in stocks goes up and may become less attractive. 

Another way to look at the relationship between the two is the opportunity cost to invest in them. When one investment opportunity becomes more attractive, if you invest in any other non-attractive product, you are basically losing out on the opportunity to get better returns and, in some way, paying an opportunity cost.

3) Bond Yields And Foreign Funds

If bond yields go up, it makes the debt market more attractive. Say Indian bond yields, at a certain time, are offering better yields than the global market; global investors will find Indian debt more attractive than global debt.

Again, if the debt market looks more attractive than equities, foreign institutional investors' (FII) flows will be bent towards equities. The concept of opportunity costs comes into play again.

Conclusion

The stock market and bond yields are two different entities, but they are closely related to each other. The stock market is the price at which shares can be bought or sold. The bond market is the price at which bonds can be bought or sold. The difference between these two markets is that stocks are traded on a stock exchange, and bonds are traded through a bond exchange.

The relationship between bond yields and stock prices in India has been changing over time. In recent years, the relationship has become more complicated, with stock markets becoming more volatile and bond yields becoming less volatile than they were before.

This has caused investors to start asking questions about what this means for their investment strategy and whether or not they should change their investment strategy based on those changes in behaviour by investors overall.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.