Explaining in simple terms, bond yields are the returns an investor gets on bonds or government securities. Once you as an investor understand bond yields, it will be easy for you to decide when to invest in stocks, when in bonds and how to easily review and rebalance your portfolio depending on the situation.
Generally, bond yields and equity markets have an inverse relationship. When yields rise, markets fall and vice versa.
This was seen in February 2021 when Indian benchmark indices fell around 2 percent in just 1 session after the US treasury bond yields surged over 6 percent, to their highest level since the pandemic began.
The main logic behind this is that when yields are higher, the investor gets a better return on bonds and hence he/she moves to more bonds and sells riskier assets like equities causing a crash in the stock markets.
There are a number of triggers as well a number of implications of a higher bond yield. Inflation and interest rates are two key triggers that affect bond yields.
A rise in inflation leads to a rise in yields as investors move money to bonds from equities under inflationary pressure. Inflation leads to rise in prices for products and services decreasing the purchasing power of people which in turn affects investment. Also, the expenses of firms increase and profits decrease impacting their share prices as well. So in order to avoid the risk, investors generally prefer bonds in a high inflationary environment.
Bond yields are highly affected by monetary policy. A fall in key interest rates increases bond prices leading to a fall in yields and vice versa. If bond prices increase, it may not be considered a very good investment option since the return would diminish and hence investors may move towards riskier bets like equities.
Impact on stock markets
There are two different scenarios: firstly a rise in yields when growth is strong and secondly rise in yields when inflation is higher.
In the first scenario, the markets will not be affected much since the rise in yields would reflect growth. When growth rises so do yields and hence, the markets will not react negatively to this kind of rise in yields that is supported by economic growth.
"When growth is strong, the impact of higher growth in terms of cash flows or, more precisely, dividends more than offsets the negative impact of the rise in yields, causing equity share prices to trade higher," Morgan Stanley explained in a note.
However, the second scenario is not very positive for the equity markets. A rise in inflation itself will keep the markets under pressure and the rise in yields on top of that would lead investors to move away from the stock markets to the bond market leading to a steep fall in equities.