Why equity bulls should fret over rising bond yields as inflation theme heats up

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NEW DELHI – As India’s economic activity progressively picks up steam following the unwinding of COVID curbs on movement, stock market investors can reasonably bet on improved growth prospects translating into better corporate earnings.

But, there is a proverbial fly in the ointment – inflation.

The pressure on profit margins emanating from rising input costs has lately been a burning topic of discussion with the country’s major consumer goods firms leading the charge through both price hikes and commentaries about the degree to which retail inflation has eroded purchasing power.

There is, however, another point of concern for equity investors, one that is also an offshoot of persistently high inflation but nonetheless not as widely discussed as the obvious hit to corporate margins – rising bond yields.


BOND YIELDS, EQUITY VALUATION


Benchmark 10-year government bond yields have hardened by 47 basis points so far in 2022 as a surge in crude oil prices since the Ukraine war has added to existing inflationary pressures, making a case for the RBI to consider rolling back accommodation.

With the government’s gargantuan borrowing programme for the new financial year set to commence this week, analysts are united in the view that the deluge of supply will send the 10-year bond towards the 7.25 per cent mark in the next couple of months. The 10-year bond yield was last at 6.92 per cent. Bond prices and yields move inversely.

For the equity market, a clear-cut consequence of this is an erosion of valuations. Equity valuations are based on the risk-free rate of borrowing which prevails in the country – the government bond yield.

Furthermore, sovereign bond yields are typically the benchmarks used to arrive at cost of capital for a firm, implying that when debt yields rise, valuations of equities take a hit.

The converse happens when bond yields fall and equities generally perform well in an easing bond yield environment. This is a key factor that boosts stock prices when the central bank lowers policy rates.

According to a study by Motilal Oswal, in the five years since 2012, while benchmark government bond yields dropped around 17 per cent, the Nifty rose around 82 per cent.

In a nutshell, a rise in sovereign bond yields therefore stands to eat into the returns offered by equities.

“Rising risk-free rate (bond yield) is resulting in equity valuation contraction which is accentuated by the rise in systematic risk due to geopolitical crisis – As articulated in our year ahead outlook for CY22, the pressure on equity valuations is emanating from rising ‘risk-free rate’) and QE reversal,” ICICI Securities wrote.

“Spike in ‘systematic risk’ due to the Russia-Ukraine conflict accentuated the pressure on equity valuations. Systematic risk is receding as the global brinkmanship reduces (although far from over) over the Russia-Ukraine conflict while the effects of rising risk-free rate driven by rising inflation persist.”

The brokerage noted that if bond yields do not surge from hereon and the earnings growth trajectory remains driven by firm exports, pent-up demand and improving prospects for the investment and credit cycle, the Nifty50 earnings yield could sustain at 5 per cent, which implies price to earnings of 20 times.

Another key way in which rising bond yields could affect equities is by determining the behaviour of overseas investors. Simply put, more lucrative returns from debt could drive investors away from the stock market to the bond market.

Interestingly, so far in 2022, FIIs have pared their exposure to Indian debt assets on a net basis by a mere Rs 3,346 crore versus almost Rs 1 lakh crore worth of equity sales.

Worryingly for stock enthusiasts, the current phase of rising bond yields is not one where optimism about growth is driving up long-term borrowing costs on the view that inflation would heat up in response.

In such a situation, firms could have banked on their dividends rising and therefore compensating for a rise in bond yields.

At present, however, long-term bond yields are rising as market participants feel that actual inflation outturns may outstrip the RBI’s forecasts, potentially compelling the central bank to swerve towards a tighter monetary policy.

Among ICICI Securities’ picks in cyclical stocks are SBI, Axis Bank, HDFC, L&T and Tata Steel. On non-cyclicals, the brokerage favours NTPC, Bharti Airtel, Tata Communications, Infosys and ITC.



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