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Sensex shoots past 62,000 peak, but yield gap in 10-year bonds sends caution

Rising interest rates and elevated stock valuation could be stretching the spread between earnings yield and 10-year GSec yield to a breaking point

November 27, 2022 / 02:42 PM IST
If bond yields continue to rise with rising interest rates, investors may have to change their debt-to-equity allocation in favour of debt. (Photo by energepic.com/Pexels)

If bond yields continue to rise with rising interest rates, investors may have to change their debt-to-equity allocation in favour of debt. (Photo by energepic.com/Pexels)

Stock markets have hit their all-time highs and the market seems to be on an upswing. But, there is an indicator—the spread between earnings yield-10-year GSec--blinking red and advising caution.

With rising interest rates and stock markets inching towards all-time highs, the gap between the yields is elevated. Nifty’s earnings yield is at 4.5 percent and the bond yield is at 7.3 percent, which means a spread of 2.8 percentage points or 280 bps, when usually the gap ranges between 25 bps and 350 bps.

Also read: Markets at all-time high: Is it time to be bullish or bearish?

“If the interest rate continues to rise or stay elevated and the spread rises to its upper limit of 3.5 percentage points, then the stock market may see a strong correction,” according to Rohit Srivastava, founder and strategist at Indiacharts.com. He shared a chart (see below) plotted with data between 2008 and 2022 year-to-date, and it showed how bond yields and spread moves in parallel and earnings yield and the spread move in opposition.

bond 2411

In the graph, the spread seems to be rising as bond yields rise on interest-rate hikes, and when the spread heads towards its upper limit, the equity yield keeps trending downwards to bottom out when the spread is around 350 bps.

Even a 350 bps may be a stretch if we go by what analysts at Jefferies had said in their September report when Nifty was at 18,000. They had plotted a Nifty price chart along with the yield spread (between 10-yr GSec yield and Nifty earnings yield), between September 2021 and August 2022. They found that whenever the yield spread rises above 2 percentage points, Nifty peaks out and corrects by over 10 percentage point. The Nifty had corrected by 6.3 percent by the end of that month.

Therefore, if bond yields continue to increase with rising interest rates, investors may have to change their debt-to-equity allocation in favour of debt.

Chief investment officer at ICICI Securities, Piyush Garg, pointed to the premium valuation of the Indian markets. “The market i.e. Nifty index is trading at 10-15 percent premium to tax adjusted 10-year yield, which is in expensive zone. Also, it is trading at around 80 percent valuation premium to other EMs. Yields have also picked up with 10 year quoting at around 7.4-7.5 percent from 6 percent a year back, and 1 year Fixed deposit has come up to around 7 percent from 5 percent a year back and may settle in the 7.5-7.75 percent range by the end of fy23.  Hence, one must look to rebalance the  portfolio with weightages of 70-30 percent debt-equity,” he said If Nifty corrects to 16,000, then an investor could look at a 40:60 debt-equity allocation, he added.

In the current scenario, investors should consider 4-5 duration mutual funds for debt assets and picking large cap names or investment in Index ETFs with a staggered approach for equity assets, according to Garg.

Even Deepak Jasani, the Head of Retail Research at HDFC Securities, suggested that some allocation can be made towards debt by moving it out of equities. “On the back of ongoing tightening in the economy with interest rate remaining at elevated levels; and Indian stock market trading near at all-time, high investors could see muted stock market performance in the near term,” he said.

While India’s earnings momentum has held up better than emerging markets (EM) peers and this has attracted foreign flows despite receding global liquidity, the momentum could weaken going forward. India Inc’s earnings could be weighed down by the tightening liquidity and weak global growth, he said. This and relatively rich valuations could weigh on earnings yields (earnings per share divided by price) further, and thus tip the scale deeper in favour of debt assets.

If we take the earnings yield to bond yield ratio (EY-BY ratio), it is at 0.62x. It isn’t very much lower than its 10-average, which is 0.64x. Therefore, Motilal Oswal Private Wealth’s Head of Investment Products, Nitin Shanbag believes that there is still a good opportunity to invest in equity markets. But, he added, it should be done in a staggered manner.

“If the ratio gets progressively higher, then investors can add to their equity allocation and if the ratio goes progressively lower, investors can look to book profits (rebalance) from equity investments,” he said.

Also read: As stocks sprint, should surging valuations worry investors?

“At the peak of the pandemic, when interest rates were cut to decadal lows, the EY-BY ratio was at 1X, signalling a very attractive opportunity to invest in equity markets. Subsequently, the equity market has recovered and interest rates have also increased significantly, resulting in the current EY-BY at 0.6X,” said Shanbag.

Elevated-rate scenario

With inflation likely to be sticky, investors are concerned that the rate hikes may stay elevated. In such a scenario, what should investors do?

MOSL’s Shanbag seemed to prefer a more cautious route. He reiterated the staggered-allocation approach towards equity over the next three to six months, with a bias towards multicap strategies and select mid- and small-cap strategies.

In fixed-income, the core portfolio can be invested in high credit quality target maturity funds (debt mutual funds) which invest in a combination of G-sec, State Development Loans (SDL) and AAA-rated debt instruments, he said.

ICICI Securities’ Garg too reiterated the 70 percent-30 percent debt-equity mix, with investors shifting to 40 percent-60 percent debt-equity mix when valuation compresses from the current expensive levels.

“Global macro environment  is expected to see lower growth in CY23 due to rising interest rates and hence lower inflation which is expected to settle at around 3 percent (US) in the end CY23. Hence the terminal Fed funds rate is expected to be around 5 percent-5.25 percent with expectation of a rate cut in the end CY23. However this may be accompanied with a recession in global economy,” he said.

HDFC Securities’ Jasani said that they believe that we are close to the peak of a rate-hike cycle. The brokerage expects softer rate hikes by the Reserve Bank of India (RBI), going ahead. Therefore, he suggested higher allocation to debt mutual fund, GSec, SDLs and other government securities, and added that investors do so in a staggered manner so that the debt holdings’ value is not dramatically impacted from forthcoming rate hikes by RBI.
Asha Menon
first published: Nov 25, 2022 03:29 pm