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Summary
- The US 10-year treasuries’ yield surpassed 1.6 per cent, highest in one year.
- Higher bond yield is theoretically bad for equity markets.
- However, high economic growth can offset the negative impact of rising bond yields.
A sharp surge in the bond yields has come again to haunt the equity markets. Last week, US markets fell sharply as the global markets traded sharply lower, amid a steep rise in the 10-year treasuries yield which has surpassed 1.6 per cent. This is the highest level in a year as key part of the treasury curve surged past an inflection point.
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Last week, Down Jones closed 1.78 per cent lower at 30,932.4, ending its 3 weeks winning streak. S&P 500 lost a decent 2.45 per cent while tech heavy Nasdaq shed 4.92 pe cent. Even the Australian market lost about 1.77 per cent. So how rising bond yields affect equity markets and consequently an investors’ portfolio?
As US economy is crawling out of the pandemic induced recession, the investors’ expectation about the economic growth is picking up stream as more economic stimulus and vaccination drive would help to make the economy stand on its feet.
Bond yield is the return an investor gets on that bond (excluding sale of that bond). When investors are bullish about the economy, they dump these safe assets and move towards more risky ones. This sell-off leads to a fall in the bond’s price which eventually leads to an increase in its yield.
Read More: ASX 200 today: Australian shares surge in opening trade, bond yields rise
How bonds affect stock market?
While investing in equities, investors seek a risk premium over the risk-free rate to arrive at an expected return. Risk premium is just an additional return that an investor demands to take additional risk in the equity market.
One of the easiest ways to calculate risk-free return is to default it to the government bond yields. Now, higher the bong yield, higher would be the risk premium that an investor would be demanding while investing in equity markets. Therefore, higher bond yield is bad for the equity markets and vice versa.
However, the rising bond also reflects growth in the economy. If the growth also picks up at a decent pace, the impact of higher cash flows and dividends could also offset the negative impact of rising bond yields.
In another case, where bond yields rise but without a visible growth, primarily because of inflation concerns, then the equity markets reflect the worry with a decline.
