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When bonds rise, its time to take stock

When bonds rise, its time to take stock
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First Published: Wed, Jun 20 2007. 12 07 AM IST
Updated: Wed, Jun 20 2007. 12 07 AM IST
Stock market investors don’t seem worried about bonds. Since the beginning of May, the yield on the 10-year US treasury bond has increased by one-half a percentage point to 5.1%. But while stocks have tumbled on the bond market’s especially bad days, the S&P 500 index is up by 3% over the period.
Stock market optimists argue that the higher yields are a good sign for equities.
They say the sellers of bonds will soon be buyers of shares. Also, bond yields may be up because US growth prospects are looking better. In turn, strong growth should push up profits and share prices.
The optimists are probably wrong. The alternative interpretations of higher yields are more persuasive, and both point towards weaker share prices.
First, higher yields could well be a first sign that investors have increased the returns they demand from their investments. That’s a plausible theory, since real yields have recently been low. The gap between the 10-year bond yield and the rate of US consumer price inflation has averaged 2% over the last five years, compared with 3% over the previous 40.
If so, a higher cost of capital is bad for equities.
When the discount rate goes up, the present value of future profit streams—the price—goes down. That’s as true for stocks as for bonds. What’s more, higher real yields will increase the cost of servicing debt, reducing the cash flow available to shareholders.
Second, investors may be looking for higher returns because they are more worried about inflation. In the long run, inflation is probably neutral for equities. After all, they largely represent claims on inflation-protected assets such as factories and goodwill.
But in the short run, inflation fears would be likely to weigh heavily on share prices. Equities are considered a risky asset, and uncontrolled inflation would make investors less willing to take risks. Also, central banks would fight higher inflation with higher interest rates—and that would be bad for profits in leveraged companies.
Bond yields have stabilized in the last few days. If they resume their rise, stock prices could well start to fall.
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First Published: Wed, Jun 20 2007. 12 07 AM IST
More Topics: Money Matters | Bonds |