How do bond yields impact stock prices?
Bond yields and stock prices are often seen as two sides of the same coin, as they both represent investments and therefore, can affect each other. Bond yields have been in the news in recent times and movements in the bond market can play a significant role in the movements in the stock market.
Bonds are debt securities. These are fixed-income securities issued by the government and corporates in order to finance projects and raise funds. A bondholder gets returns in the form of an annual interest rate and the principal amount is returned once the bond reaches maturity.
Bond yield simply represents the returns on the amount invested in the bonds. Bond yields move in the opposite direction to bond prices. When bond yields rise, bond prices fall, and vice versa. The bond yields have a significant impact on the equity markets.
When bond yields rise, it usually indicates that interest rates are increasing, which can lead to higher borrowing costs for companies. This, in turn, can reduce their profits, which can result in lower stock prices.
Rising bond yields also make bonds more attractive to investors as a source of income, while stocks may become less attractive. When capital shifts into the bond market, demand for stocks may decline, leading to lower stock prices.
In essence, bond yields depict the opportunity cost of investing in equities. For instance, suppose the yield for a 10-year bond is 6% per annum. Investors will be attracted to the equity market only if it can deliver returns higher than 6%. Therefore, as bond yields rise, the opportunity cost of investing in equities also rises.
Expectations for Future Growth
Increasing bond yields can also signal expectations for higher economic growth, which can lead to higher inflation. Bond yields tend to increase with growing inflation. Therefore, investors can often choose to allocate funds to bonds at such times.
Moreover, bond yields also play a critical role when it comes to fund flow in the global market. Foreign Institutional Investors (FIIs) would choose to invest in a country’s bonds if the yields are increasing.
The bond market is a useful indicator of economic conditions as it reflects the direction of interest rates and can also provide insight into the health of the economy and its near-term prospects. Investors can track the yield of various bonds to get a sense of the current economic environment and how it may affect their investments.
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