Over the past few days, a bold surge in yields has contributed to a sharp drop in equity markets. The Nifty and Sensex fell about 2% on Monday, falling for the fifth session in a row. In contrast, the yield on the benchmark 10-year government bond 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.
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Higher interest costs for businesses: A rise in bond yields denotes higher interest rates in the economy. Higher interest rates drive up the cost of business loans 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 flow is losing 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 ten 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 return stocks to their bullish path. Market participants are likely to closely monitor the central bank to determine the direction of the stock and bond markets.