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

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. Not just domestic bond yields, a movement in U.S. bond yields have also affected stock markets back home. A rally in the Indian markets had taken place due to a sudden increase in U.S. bond yields during March 2021. 

Let’s understand the relationship between bond yield and stock prices and the impact of U.S. bond yields on Indian stock markets.

Relationship Between Bond Yields And Stock Market

1. Bond Yields And Cost Of capital

Higher government bond yields would mean that the borrowing costs for companies have increased. Bond yields are usually used as the risk-free rate when calculating the cost of borrowing capital. When bond yields go up, the cost of borrowing also increases.

When it becomes more expensive for a company to borrow money to sustain its business, it impacts the company’s valuation and stock performance. Expensive borrowing also means lesser funds are available with the company to give out as dividends. 

2. Opportunity cost

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. 

Bonds compete with stocks as an investment. 

Hence, 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. This is not the foremost reason but it is definitely one of the factors why the two are inversely related to each other.

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.

What Is Meant By Bond And Bond Yield?

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. Bond issuers need to repay you the principal value upon the maturity of that bond.

Yield is the effective rate of return you receive on maturity after selling the bond. When 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.

Key Takeaways

• A spike in the US bond yield can influence the Indian economy.
• There is a considerable difference between bonds and stocks. You will get partial ownership of a company or organization by investing in stocks. On the contrary, you can define bonds as a loan given to a company or government by you.
• There is a crucial relationship between stocks and bonds. Bond yields affect the stock market. Bonds and stocks usually move in a different direction. Hence, you need to be very careful before investing.

FAQs

• How can investors use the bond yields?

Yields can be used to investigate the bonds in a more sophisticated manner. Investors need to understand the yield curve to take advantage of investments.

• Are high-value (yield) bonds better than low-value (yield) bonds?

It entirely depends on your objectives and circumstances.

• How are bond yield and bond prices related?

They are inversely related to each other. When one rises, the other falls.

• How do rise/fall in bond yields affect stock markets?

A rise in bond yields may swing investors away from stock markets as the former may seem more attractive. This is in case the rise in yields is offering a better opportunity to such investors when compared to equity markets.