Rising bond yield could alter risk-reward play, scupper stock market rally

The "risk-free" yield on 10-yr g-sec is a threshold for investors. If its softens, investors get into riskier assets like equities. If it hardens, they settle for attractive risk-free rate on offer

Rising yields on the 10-year government security (G-sec) could be speed-breaker for the current stock market rally, given it would alter the risk-reward equation.

In recent weeks, yield on the 10-year G-sec has risen as much as 40 bps to trade above the 6-per cent mark.

The ‘risk-free’ yield on the benchmark government security often acts as a threshold for investors to take risks. If the yields soften, investors are lured into investing in riskier assets like equities, while if the yields harden, the appetite diminishes and investors settle for the attractive risk-free rate (RF) on offer.

Stimulus measures by global central banks this year have pulled down the RF, thus boosting prospects for equities. “An argument for the current rally in global equities is that the ‘discount rate’ has dipped sharply on account of the unprecedented accommodative stance of global central banks in response to Covid, which has brought down the RF at a time when rising risk appetite is reducing the ERP (equity risk premium),” says Vinod Karki, head (strategy), ICICI Securities. Karki says that since 2018, the RF for India has dipped 200 bps, which has reflected in higher equity valuations in the absence of earnings growth. Interestingly, the fall in RF in the US has been sharper. The difference between the peak and trough yield for the 10-year security in India has been 90 bps this year, while in the US it has been 140 bps.

 

 

“Sticky consumer inflation at 6.5 per cent and a sharp increase in fiscal deficit outlook has resulted in the 10-year bond yield remaining relatively high, despite rate cuts and liquidity measures by the RBI,” says Karki.

During the 2008 global financial crisis (GFC), the RF for India had shown a sharper drop than the US. The peak-to-trough difference between 2007 and 2009 for India was 420 bps (10-year bond yields came off from 9.5 per cent to 4.2 per cent); in the US the drop was 320 bps (10-year bond yields came off from 5.3 per cent to 2.1 per cent). ICICI Securities says the rising RF, coupled with the P/E multiples being above the historical average, could signal trouble for equity markets.

“Covid impact of a sharp dip in forward earnings growth, and dip in ‘discount rate’, will provide headwinds to the current rally in Indian stocks, as valuations rise above one standard deviation on a rolled-forward P/E basis. Our 1-year ahead target for the Nifty50 remains at 11,700,” says Karki.