Why are rising bond yields pushing stock markets down?


In recent days, a surge in bond yields has contributed to a sharp decline in equity markets. The Nifty and Sensex fell around 2% on February 22, adding to losses earlier in the week. The yield on 10-year benchmark Indian government bonds, meanwhile, climbed to 6.20% from around 5.80% at the start of the year.

mint explains how the two concepts are related and what is the connection.

Higher Interest Costs for Businesses: Rising bond yields denote higher interest rates in the economy. Rising interest rates drive up the cost of loans to businesses and prevent them from borrowing additional money to invest. This ultimately affects their profits and therefore shareholders’ returns. The actions of highly indebted companies are particularly affected. The higher rates are also affecting consumers by driving up the costs of items such as home loan IMEs. This reduces the overall demand in the economy.

Business cash flows lose value: a stock is valued as the discounted sum of its cash flows. There are two components to this concept. First, a sum of the cash flows. For example, if the business is expected to generate 1 crore each year for the next 25 years and zero thereafter, the value of the stock would be 25 crore. However, 1 crore after three years is worth less than 1 crore today because of inflation. It is even more true of 1 crore after five years or 10 years. Therefore, stock analysts apply what is called a “discount rate” to cash flows, assigning lower values ​​to cash flows that extend more and more into the future. This discount rate is the risk-free interest rate in the economy. When the risk-free interest rate increases, the value assigned to cash flows decreases. The rise in bond yields implies a rise in the risk-free rate and therefore a fall in equity valuations.

The RBI’s intervention in debt markets could lower bond yields and put stocks back on their upward path. Market participants are likely to closely monitor the central bank to determine the direction of the stock and bond markets.

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