What are bonds and how do bond yields affect the stock market?


What are bonds and how do bond yields affect the stock market?

March 22, 2023
What are bonds and how do bond yields affect the stock market?

The financial markets are interrelated and any movement in one asset class impacts the performance of another asset class. Similarly, there are multiple factors that influence the performance of equity markets. One such factor is the movement in bond yields. Let us understand what bonds and bond yields are and how they impact the stock market.

There are various financial instruments for investors to put their money in depending upon their financial goals and risk appetite. Among these, bonds are popular debt instruments issued by companies and governments.

What are bonds and bond yields?

Bonds are fixed-income securities through which borrowers, typically corporates or governments, raise money from investors who lend money for a specific time period. The issuer of the bond pays investors a fixed rate of interest during its tenure, known as the coupon rate. Investing in bonds helps investors to effectively diversify their portfolios and secure a steady stream of income.

Bonds are tradable instruments and preferred by investors with low-risk profiles expecting regular returns on investment. The returns generated by bonds are typically measured in terms of bond yields. Bond yield is the return on investment that an investor earns from a bond.

Bond yields reflect the interest rate that is paid to the bondholders as a percentage of the bond’s face value. It is a function of the prevailing market rates and determines the effective rate of return received when the bond is sold on maturity. For bondholders, yield is the summary of the overall returns accounting for the remaining interest and principal payments that they will receive, relative to the bond’s price. On the other hand, bond yield for the issuer shows the annual cost of borrowing by issuing a new bond.

If the bond yields are higher, the returns on the investments will be higher. A lower bond yield reflects lower returns. Higher yield also reflects higher risk.The current bond yields depend upon the price of the bond and its coupon or interest rate. A bond can be purchased at its face value, at a discount or at a premium. This also impacts the yield earned on the bond.

It is important to note that bond yields are inversely related to bond prices. When the yields rise, the prices of existing bonds fall. This is because new bonds with higher yields will become more attractive than the old bonds offering lower yields.Similarly, bond prices are impacted by changes in interest rates. When the interest rates rise, the new bonds issued will come with higher coupons and offer higher returns to investors. This will make currently issued bonds less attractive as they offer lower interest. The rate of interest is fixed and hence can’t be increased by the issuers.

Therefore, the prices of existing bonds go down when interest rates rise. On the contrary, when interest rates fall, the prices of currently issued bonds rise.

Impact of bond yields on the stock market

In theory, rising bond yields are generally seen as negative for equity markets. Let us understand how bond yield affects the stock market.

Firstly, when the bond yields rise, it means the returns generated by the bonds will be higher. When the yields are higher than the returns from the equity market, the bonds become more attractive than equities for investors as this also increases the opportunity cost of investing in the stocks. This will see a flight of capital from equities to high-yielding bonds.

Bond yields determine the cost of capital for companies. The yields are used as the risk-free rate while calculating the cost of capital. With increasing bond yields, the cost of capital rises, leading to future cash flows getting discounted at a higher rate. This pressurises the stock values.Moreover, higher bond yields make the debt market more attractive for foreign investors. Foreign institutional investors (FII) will shift their money towards the debt market as it becomes more attractive than equities.

Also, the cost of debt for companies and businesses rises with the increase in bond yields. It means that the companies will have to pay higher interest on their debts, which can impact their profitability and cash flows. Thus, highly leveraged companies are vulnerable to changes in bond yields.

The equity market and the bond market, though different, are related to each other. Bond yields provide investors with valuable insights into the current and future direction of the economy and markets and are also used to determine the profitability of investments.

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.

R. Kalyanaraman
by R. Kalyanaraman

Chief Executive Officer

I am a sales guy at heart with utmost willingness to listen to people – customers, employees, competitors et al. Nothing gets me a bigger adrenaline rush than an interesting conversation with my customer!