THE ‘BOND’ WITH EQUITY AND FIIs

The markets have suddenly become more about bonds and less about equity!

FIIs selling stocks worth almost Rs.8500 crore on the 26th, made everyone sit up and take notice. Most on the Street could not fathom why? Everyone knew that there was a disconnect between the market and the real world and now when the real world was slowly getting back up, why was the market tanking, that too, big time?

All heard only one reason – rising bond yields? And most were baffled – how come rising yields, that too on US Treasury Bonds was causing so much upheaval here in the stock markets? The mayhem in the stock markets is a residue of the bond market and money market panic.

Well, historically, this is how it has always been – whenever bond yields rise, equities fall. For most of us understanding this bond market and its yields is often like a Rubik’s cube – you quite know it but do don’t really quite get it. So, to understand this current situation better, a quick understanding of this bond market dynamics.

What is the co-relation between bonds and yields?

They both, the price of the bond, which is the face value of the bond is inversely proportionate to the yields. Imagine the price and yield sitting on a see-saw. When price goes up, yield will come down and when price goes down, yield will go up. This is probably the most simplistic way of understanding this concept.

What about interest rates and bond markets?

Interest rates and yields move in the same direction, so that naturally means interest rate and bond price move in opposite direction.

How to calculate bond yields?

It is simple math – coupon rate/face value of bond.

Suppose you have a Rs.1000 face value bond and coupon rate of 7%, then the yield is 70/1000 = 7%.

How do yields give an indication of the stock markets?

If yields go up, it means there is trouble on the horizon and this always indicates a negative market condition.  Yield and risk go hand-in-hand. Higher the yield, higher is the risk – so you get paid as per the risk in the market. As bond yields rise, the opportunity cost of investing in equities goes up, and equities become less attractive. Also when yield goes up, the cost of capital for companies goes up, which in turn brings down the valuation of the stock.

How does this affect you as a trader and as an investor?

When bonds are traded in an open market, yield will be the profit which you make on the purchase of bond. Thus when bond prices fall, yields will rise and that will make purchasing the bond in the open market unattractive as the face value would have got adjusted lower to adjust to the higher yield.

For eg: Suppose you have purchased a bond A with a coupon rate of 6% and face value of Rs.1000 for 10 years. Your yield is 6%. Bond B is issued with a coupon rate of 7% thus yield also moves to 7%. The face value now has to adjust downwards to accommodate the higher yield, working out at Rs.857. This in short explains why traders dump bonds in a rising yields market.

So, why are FIIs selling equity in India?

A higher bond yield in US forces the FIIs to move their asset allocation from riskier emerging markets equities or debt to US Treasury and that’s why we witness this outflow of funds. And within India, when yields on domestic bonds rise, money will move from equity to debt.

Now let’s try and understand why yields are rising and mind you, this happens every time the economy starts getting back on track after a big slump. There are quite a few reasons:

1: Rising inflation in US means interest rates cannot be kept the near-zero rates for “as long as it takes.” Thus traders are fearing the Fed will hike rates and thus yields are going up.

2: Another set of analysts say that rates might not be tinkered with but the Fed might soon start tapering the asset buying program and that probably is the biggest risk to which bond markets are reacting.

3: One fear is feeding into the other, and this has created a vicious circle, going completely out-of-hand.

4: Many call this a “technical reason” – convexity hedging and negative hedging.

5: The $1.9 trillion stimulus package – once that gets the go-ahead, yields could go up further.

It is expected that the Fed will soon address market concerns of a premature withdrawal of Fed support and highlight the longer-term challenges in a post-Covid world. Till then, we could see some more volatility and this presents us with a buying opportunity in equity.

Bottomline – yields are going up because the economy is getting better due to which interest rates could go up sooner than expected. Pay attention to “economy is getting better”