Impact of Rising Bond Yields on the Equity Market

Global Bond Yields Surge Amid Inflation Concerns and Geopolitical Tensions

Bond yields, a crucial measure of interest rate expectations in the economy, have seen a significant surge in recent times. This development has raised concerns for financial markets amid ongoing inflationary anxieties, geopolitical conflicts, and expectations of elevated interest rates.

The US 10-year Treasury yield has exceeded 4.6%, bolstering the dollar and diminishing global risk appetite. The increase in bond yields has raised borrowing costs, put pressure on equity valuations, and prompted capital flight from emerging markets such as India. Rising crude oil prices, driven by US-Iran tensions, have further fueled inflation concerns and amplified market volatility.

Understanding Bond Yields

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Bond yields move based on inflation expectations, interest rate outlook, economic growth, and investor demand for safe assets. One of the most important concepts in the bond market is that bond prices and bond yields move inversely. When bond prices fall, yields rise, and when bond prices rise, yields decline.

Bond yields usually rise when inflation increases because investors demand better returns to compensate for the loss in purchasing power. Yields also rise when central banks, such as the RBI or the US Federal Reserve, raise interest rates, as newly issued bonds offer better returns than older, lower-yield bonds. Strong economic growth, higher government borrowing, and surging oil prices can also push yields higher by increasing inflation concerns.

On the other hand, bond yields fall when inflation cools, growth slows, or central banks signal interest rate cuts. During periods of uncertainty, investors often allocate capital to government bonds, which are considered safer assets. This higher demand pushes bond prices up and yields lower.

Impact on Banks

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Rising bond yields can create near-term pressure on banks, particularly PSU banks, many of which hold sizeable government bond portfolios in their treasury books. Since bond prices move inversely to yields, an increase in yields leads to a decline in bond prices, resulting in mark-to-market (MTM) losses on investment portfolios. These are largely notional losses rather than actual cash outflows.

Impact on Indian Equity Markets

The rise in US Treasury yields can impact Indian equity markets by slowing down or moving out temporary foreign money. For Indian equities, the impact is usually felt first in rate-sensitive sectors like IT and banks, as well as in high-valuation, growth stocks. A sharp rise in US yields can also pressure the rupee and tighten global liquidity.

However, India is no longer just a ‘risk-on trade’. Strong domestic SIP flows and improving economic fundamentals now act like shock absorbers. So while rising US yields can create volatility and compression in valuations, they don’t automatically derail the long-term India story.

Pressure on Corporate Borrowing Costs and Equity Valuations

The rise in bond yields essentially indicates that interest rates in the economy are moving higher. From an equity market perspective, this has two key implications. Higher bond yields translate into a higher cost of borrowing for corporates. Whenever companies refinance existing debt, raise fresh borrowings, or service loans linked to benchmark lending rates such as MCLR, the cost of capital tends to increase.

As a result, finance costs for listed corporates are likely to rise, potentially affecting profitability going forward. Rising bond yields also push up the risk-free rate in the financial system. In valuation terms, a higher risk-free rate increases the discounting factor used in equity valuation models. The moment the discount rate rises, the present value or fair valuation of future cash flows declines.

Table: Factors Affecting Bond Yields