Inverse correlation: Why falling bond yield is good news for equities

ET Intelligence Group: Falling bond yields are proving to be beneficial to Indian equities.

Indian benchmark bond yield dropped nearly 90 basis in the past six months following stable inflationary expectation and change in the benchmark bond yield instrument. During the same period, the price-earnings (PE) multiple of Indian equities expanded to 18.1 times the projected FY18 earnings from 15.6 times in April 2016 -a gain of 15.7% which is the secondhighest among emerging markets (EMs) after Argentina.

According to the finance theory postulated by Myron Gordon, bond yields are inversely correlated to PE. This is because to arrive at the fair value of equity of a company, the free cash flows net of payment to lenders are discounted using the cost of equity (CoE). CoE, in turn, is derived from the bond yield, or better known as the risk-free rate.

Hence, a drop in the bold yield leads to increases in the fair value of equity thus raising the numerator of the PE ratio and also the overall ratio. CLSA, in a recent report, said that keeping other parameters constant, a 10 basis point change in the risk-free rate in India may increase the fair value of equities by 3-5%. Similarly , for stocks which are valued on the discounted cash flow (DCF) basis, a lower cost of equity will boost the fair value of the company.

The moderation in the bond yield is also increasing attractiveness of equities based on the relative earnings yield, which is calculated by inversing the PE ratio. If the earnings yield is higher than the bond yield, stocks are considered to be undervalued relative to bonds. The earnings yield spread of the Sensex relative to the Treasury yield is trading below its average of 1.59.

The trailing earnings yield is 5.52% while the bond yield is 6.67%.The difference between them has dropped to 115 basis points (bps) from 202 bps in April, according to data from Bloomberg.