Home >Markets >Stock Markets >Why are increasing bond yields pushing the equity markets lower?

Over the past few days, a surge in bond yields has contributed to steep falls in the equity markets. The Nifty and Sensex dropped by around 2% on 22 February, adding to losses earlier in the week. The benchmark Government of India 10-year bond yield, on the other hand, has 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 make 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 10 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 the cash flows drops. Rising bond yields imply a rise in the risk-free rate and hence lower equity valuations.

The RBI’s intervention in 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.

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