1 min read.Updated: 23 Feb 2021, 10:24 AM ISTNeil Borate
Higher interest rates push up the cost of loans taken by companies and makes it harder for them to borrow additional money to invest. This ultimately affects their profits and hence the returns of shareholders
Over the past few days, a surge in bond yields has contributed to steep fall in equity markets. The Nifty and Sensex dropped around 2% on Monday, falling for the fifth consecutive session. Yield on the benchmark 10-year government bond on the other hand, climbed to 6.20% from around 5.80% levels at the start of the year.
Mint explains how the two concepts are related and what the connection is.
Higher interest costs for companies: A rise in bond yields denotes higher interest rates in the economy. Higher interest rates push up the cost of loans taken by companies and makes it harder for them to borrow additional money to invest. This ultimately affects their profits and hence the returns of shareholders. The stocks of companies with a large amount of debt are particularly impacted. The higher rates also affect consumers by pushing up costs on items such as home loan EMIs. This reduces the overall demand in the economy.
Cash flows from companies lose value: A stock is valued as the discounted sum of its cash flows. There are two components to this concept. First, a sum of cash flows. For example, if the company is expected to generate ₹1 crore every year for the next 25 years and zero thereafter, the value of the stock would be ₹25 crore. However, ₹1 crore after three years is worth less than ₹1 crore today because of inflation. This is even more true of ₹1 crore after five years or ten years. Hence, equity analysts apply what is called a ‘discount rate’ to the cash flows, assigning lower values to cash flows that are further and further in the future. This discount rate is the risk-free interest rate in the economy. When the risk-free interest rate rises, the value assigned to cash flows drops. Rising bond yields imply a rise in the risk free rate and hence lower equity valuations.
RBI intervention in the debt markets could bring down bond yields and return stocks to their bullish trajectory. Market participants are likely to keenly watch the central bank for direction in the stock and bond markets.