Gap between bond, earnings yields spells more pain for equity investors

Bond yields 380 bps higher than average earnings yield of BSE500 companies

The equity market might see more selling in the coming weeks, as there is still a large gap between the yield on the 10-year government bond and corporate earnings yield, despite the recent correction in the broader market. The bond yields are now higher by 380 basis points (bps), compared to the average earnings yield of BSE500 companies. This is nearly 150 bps higher than the 10-year average yield spread of 230 bps. One bps is one-hundredth of a per cent. (See chart).

Earnings yield is calculated by dividing a company’s latest trailing 12-months (TTM) net profit by its market capitalisation and shows the potential yield for an investor if the company distributes its entire annual profit in the form of equity dividends. As bond yields stand for income on a risk-free asset, higher yields reduce the attractiveness of equity, which is a risky asset and vice versa. Analysts say this imbalance can only be corrected either if there is a strong double-digit growth in corporate earnings in the forthcoming quarters or if the stock prices decline further or if there is a sharp dip in bond yields. There is a low probability of a rapid scale-up in corporate earnings, given the historical trend of single-digit earnings growth. A significant decline in bond yields can happen in case of a global hardening of yields and India’s rising fiscal deficit.

Historically, there is a negative correlation between stock prices (read market capitalisation) and the spread of bond yields over earnings yields. For example, the post-Lehman rally on Dalal Street was preceded by a period of historically low (negative) yield spread. 

Similarly, the current rally that started in the middle of 2013 was preceded by below-average yield spread. Again, the market correction in 2016 was preceded by higher than average yield spread (See chart).   

Analysts say the correction will be much bigger in mid and small cap stocks compared to benchmark indices, as earnings yields are much lower there.