How rising bond yields and interest rates are putting pressure on stock market valuations

The disconnect between market performance and corporate profitability has become one of the most notable features of 2026. During the first 10 months of the year, the Nifty 50 declined on 106 of 204 trading sessions, resulting in a loss of more than 11.8%.

The weakness in stock prices is particularly striking given the steady improvement in earnings. Nifty 50 companies reported year-on-year earnings growth of 4% in the March 2026 quarter, accelerating to 18% in the June 2026 quarter. According to Motilal Oswal Financial Services’ interim earnings review for the September 2026 quarter, the recovery is becoming increasingly broad-based across sectors, despite ongoing com modity cost pressures and global eco nomic uncertainty.

So, if earnings are getting better, why are markets volatile? One of the key forces behind this disconnect is not inside corporate balance sheets, but in the bond market.

Rising bond yields

When government bond yields rise, investing in risk-free sovereign debt suddenly becomes much more appeal ing. Over the past year:

*India’s 10-year G-sec yield rose from 6.5% to 7.4%, pushed by elevated crude prices, inflation pressures, and repo rate hikes by the Reserve Bank of India (RBI).

*US 10-year Treasury yield jumped from 3.8% to 5.3% in the first week of October 2026 (it was 5% at the end of October), drawing global capital back to dollar-backed safety. Foreign Portfolio Investors (FPIs) pulled more than Rs.2.8 trillion out of Indian equi ties between January and October 2026.

Equities are riskier than sovereign bonds. If a virtually risk-free government bond pays 7.4%, investors won’t settle for the same return from volatile stocks they accepted when bonds yielded 5% or 6%. To take on equity risk, investors demand a higher return (a higher discount rate).

How the discount rate compresses valuation

A company’s value is based on the cash it is expected to generate in the future. But a rupee received five years from now is not worth the same as a rupee received today. If an investor has `100 today, he can invest it and earn a return.

Coming to the equity market, the future earnings of a company are uncertain. Investors, therefore, convert future cash flows into their present value by applying a discount rate. The discount rate reflects the return they could earn elsewhere, and the risks associated with the investment. A higher discount rate means a lower pre sent value.

Consider a company that generates Rs.100 in annual cash flow available to shareholders, which it distributes as dividends. Assume this cash flow remains unchanged indefi nitely. Using a simple zero-growth perpetu ity model, the value of the company is calcu lated by dividing its annual cash flow by the required return (see table 1).

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Notice the earnings stayed the same (Rs.100) and the business has not deteriorated. However, as the discount rate increased from 5% to 10%, the valuation fell from Rs.2,000 to Rs.1,000. So, when investors demand higher returns, they are willing to pay less for the same earnings. This is the basic mechanism through which rising interest rates can reduce stock valuations.

Which stocks are more vulnerable?

The P/E compression trap

The price-to-earnings (P/E) ratio tells investors how much they are paying for every rupee of a company’s annual earnings. If a stock trades at Rs.1,000 and its annual earnings per share (EPS) is Rs.50, its P/E ratio is 20.

The inverse of the P/E ratio is called the earnings yield. In simple terms, earnings yield tells investors how much a company earns for every rupee invested in its shares. A higher P/E means a lower earnings yield, while a lower P/E means a higher earnings yield.

Now consider a market index with an EPS of Rs.200. At a P/E of 20, the index value is Rs.4,000. Its earnings yield is 5%, or inverse of P/E ratio, expressed as a percentage. The calculation is straightforward (see table 2).

Suppose interest rates rise, and investors begin demanding a higher return from equi ties. For a simple illustration, assume that investors now require an earnings yield of 7%. The index would have to fall to a lower level to offer this higher earnings yield, as suming earnings remain unchanged.

Can earnings offset valuation declines?

Yes. When P/E falls, earnings must run faster just to keep the stock market standing in the same place.

In table 2, for the index to stay at 4,000 un der a demanded 7% earnings yield, earnings or EPS must expand dramatically. EPS must jump from Rs.200 to Rs.280—a 40% surge—just for the market price to stand completely still. If earnings grow by 15% or 18%, that is not fast enough to outrun multiple compres sion, and the index value falls anyway. This explains why markets do not respond to the earnings improvement.

When can equities defy high yields?

A rise in bond yields does not automatically mean that equity markets must fall. The impact depends on why yields are rising and whether earnings expectations are improv ing or deteriorating.

If yields rise because inflation is increas ing and investors demand greater compen sation for risk, the impact can be particularly challenging. Higher input costs may weigh on profit margins, while the higher discount rate puts pressure on valuations.

But if yields rise alongside strong econom ic growth and improving corporate earnings, the effect can be partly offset by better earnings expectations.

Note: The India 10Y and US 10Y bond yield data is sourced from Bloomberg. Earnings yield is a proxy for the return demanded by shareholders. Expected returns also depend on future earnings growth, dividends and risk. All numbers used in illustrations are hypothetical.