Market experts feel that it is only a matter of time before the stock market reacts to the surge in bond yields.
A rule of thumb in financial markets is that stock prices cannot keep rising if bond yields are also on the way up. This hypothesis is being tested in the Indian markets at the moment. Yields on 10-year government bonds have risen 61 basis points in the last three months. But the stock market has taken it on the chin, with the Nifty rising 7.6 percent during the same period and the Bank Nifty, 6.2 percent.
And yet, market experts feel that it is only a matter of time before the stock market reacts to the surge in bond yields.
Is it the first time that the traditional correlation between equity prices and bond yields is breaking? Or is it that no overt correlation ever existed in the Indian context?
What history tells us about the relation between equity and bond market
We examined four episodes in the past when bond yields rose sharply.
The first was between June 2005 to August 2006 when the 10-year benchmark rose from 6.8% to 8.3% - both Nifty and Bank Nifty took this surge positively and maintained their uptrend.
The next one was in the run up to the Lehman collapse, when yields hardened significantly in matter of few months. The overall risk aversion in the system resulted in deep cuts both in the Nifty as well as Bank Nifty.
The post-Lehman recovery saw a steady rise in benchmark yields over the next couple of years. However, the euphoria of the recovery was reflected in the sharp surge in both the Nifty and the Bank Nifty.
2013 “taper tantrum” (fear of US Federal Reserve bringing an end to its loose monetary policy) also led to a sharp spike in bond yields in a short period of time. While Bank Nifty witnessed a correction during this period, as theory would suggest, the reaction from Nifty was an overall positive.
What is interesting to examine is the inflation rate over this period. The first episode of 2005-06 was a period of relatively benign inflation and that could explain the divergence in the reaction of the equity and bond market.
2008-09 was an exceptional period when not only risk aversion was at its peak, so was inflation. In fact, the correction in the bond market in 2013 was also accompanied by high inflation in double-digits. In contrast, albeit the inflationary pressures now, headline inflation has not yet reached the danger zone although the movement in crude oil and global commodities remain key imponderables.
Why bother about the correlation?
It's when this correlation breaks down that investors start to worry. That's because, when stocks and bonds move in opposite directions, it is often a sign that the market trend is about to reverse.
Stocks tend to rise when the economy is either doing well or starting to show signs of improvement. That is because corporate profits rise when the economy is doing well, and this encourages investors to pay more for equities.
However, rising profits can also lead to increased inflation. At some point, the central bank may try to rein in inflation by raising interest rates. However, as long as profits are increasing, stock prices could keep rising, while bonds could continue to fall even while rates are falling.
The moot question for Indian market is how should we read this positive reaction from equities?
After a dull start to FY18 on account of GST implementation, earnings have improved in the second quarter and the momentum is expected to sustain on account of a favourable base of last year (H2 FY17 impacted by demonetisation).The single-digit earnings growth for FY18 looks likely on the cards.
However, the moot question is the 20 percent plus earnings growth that the market is betting on for FY19. Can a surge in bond yields puncture those hopes?
Our analysis of past ten-year data for Nifty companies suggest that large companies in India have very low leverage with interest to sales ratio at 1.7 percent. The interest coverage ratio is close to 8.8 times. Unless there is a sharp surge in interest rates, profitability wouldn’t be impacted. For banks, the gains from the bond portfolio would dissipate when yields rise, but they would manage to maintain/improve margins in the first stage of the rates hardening cycle.
However, for second and third tier companies, the leverage position is not exactly that comfortable with interest to sales ratio of 4 times and interest coverage ratio of 2.8 times. Hence investors should consider each stock by its individual merit and avoid companies with excessive leverage or financial companies over reliant on wholesale borrowings.So while overall markets might still not react to hardening of bond yields in the current phase as well, brace for stock specific reactions.