US bond yield spike spooks Street

Analysts see correction as a trend reversal that could last a while

After a two-month rally in stock prices that pushed the benchmark BSE Sensex beyond 60,000, Dalal Street took a breather on Tuesday, closing with losses of 0.7 per cent or 410 points. Despite this, the index is still up nearly 15 per cent since the beginning of August.

Many analysts see Tuesday’s correction as a trend reversal that could last a while because of a steady rise in the 10year US bond’s yields that acts as a benchmark for interest rates in the United States and across the world.

US bond yields rose by nearly 5 basis points (bps) or 3.3 per cent on Tuesday. With this, it has risen about 25 bps or nearly 20 per cent since the beginning of September as investors seek higher yields as compensation for persistently high inflation. The yields have also moved up in anticipation of a rate hike and a gradual end of the US Federal Reserve’s (US Fed’s) bond buying programme.

Higher yield or interest on US government bonds makes equities less attractive.

“A steady rise in the bond yield in the US and the expectation of further rise in the coming months is leading to a re-pricing of equity assets and this is what we saw on Tuesday,” says Dhananjay Sinha, managing director and chief strategist at JM Financial Institutional Equity. And he feels this process could continue for a while.

“The US Fed has only announced a tapering timeline but is yet to raise interest rates or stop the bond purchase. As such, the liquidity in the market remains and some long-term institutional investors have begun to rejig their portfolio for a high interest environment,” adds Sinha.

Earnings yield

The bond and equity markets are connected through the spread between the earnings yields on stocks or indices and bond yields. Earnings yield is the inverse of a stock’s price-to-earnings (P/E) multiple and indicates the potential dividend yield for an investor if the company pays out its entire annual profits as equity dividend. The higher the stock P/E multiple, lower the earnings yield.

The Sensex ended Tuesday with an earnings yield of around 3.2 per cent, given its P/E multiple of 31x. Long-term equity investors usually expect a premium in earnings yield over the treasury yields to compensate for the risk involved.

In the last 10 years, the Sensex’s earnings spread over 10-year US treasury has been 280 bps on average. However, it has declined now to 168 bps — the lowest in two months.

Analysts expect a further contraction in the spread either if the US bond yield continues to rise or stock valuations remain high in India.

Rate hikes

The US Fed had indicated a total of seven rate hikes over the next two years that could potentially push the 10-year treasury yield to around 3 per cent, adding more pressure on equity prices in emerging markets such as India.

“At the current level, the Nifty50, for example, is trading at 24 times its expected earnings in FY23. This does not provide investors the margin of safety for the potential downside risks. A 10-12 per cent correction that will take forward P/E to around 20-22x would be healthy for the market in the current context,” says Shailendra Kumar, chief investment officer of Narnolia Securities.

However, others see only a mild correction at the index level due to stock rotation.