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A bond is a fixed-income instrument that is issued against a loan from a company or government agency. Just like you borrow from a bank or other organization, businesses or government agencies also borrow from individuals or businesses to meet their needs. Just as stocks represent a company’s ownership unit, bonds represent loans to borrowers. Thus, bonds are units of debt issued by companies and can be bought and sold like stocks.
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What are bonds and bond yields?
A company may issue bonds to raise capital for the going concern. In return for bonds, companies pay regular, fixed interest to bondholders. The interest rate paid on a bond is called the bond interest rate. It is based on the face value of the bond and is fixed until the bond matures. However, interest is not the only return to be expected from bonds. Since bonds are tradable, they can also generate a return known as a bond yield.
What is a bond yield and what does an increased bond yield mean?
In exchange for lending money through bonds, bond issuers agree to pay investors an interest rate for the life of the bond. The bond issuer must also repay the principal amount when the bond matures.
Yield is the return you get when you invest in a bond. Here is a simple example to understand productivity:
Yield = coupon amount / price
How are bond yields and bond prices related?
Bond yields are inversely proportional to bond prices because when bond yields increase, bond prices fall. This is mainly because higher yields make new bonds a lucrative option compared to older bonds that offer lower yields.
How do bond yields increase?
When investors sell bonds, bond prices fall and bond yields increase. Higher returns are a sign of higher risk. If the yield on a 10-year bond is higher than the yield at the time of issue, this indicates that the company or government is under financial pressure and may not be able to repay the principal.
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Impact of changes in bond yields on the stock market
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Opportunity cost of actions
Bond yields are important in calculating the opportunity cost of stocks. This is representative of the opportunity cost of stock investments. As bond yields increase, so does the opportunity cost of investing in stocks. As a result, stocks may not be attractive to inventors. This highlights the negative relationship between bond yields and the stock market.
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Comparison with earnings yield
Bond yields are often compared with earnings yield. So, what is earnings yield?
Earnings yield = Earnings per share / price of the stock.
It is an indicator of a share’s earnings if an investor buys it at the current price. A stock will be attractive for an investor only if he/she can get a higher earnings yield from it than the bond yield. However, this argument may not apply if the company is making a loss and an investor decides to buy their stock in the hope that the stock’s performance will change.
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Impact on the cost of capital in stock valuation
Bond yields are often used as the risk-free rate when estimating the cost of capital. As bond yields increase, so does the cost of capital. Therefore, future cash flows are discounted at a higher rate. This causes the valuations of these stocks to drop, which is one of the reasons the stock performs so well whenever the RBI cuts rates. When a company finds it expensive to borrow money to support itself, its valuation will suffer along with the performance of its stock. Expensive borrowing results in the company having less capital and thus fewer opportunities for dividends. Here’s how bond yields affect stock valuations.
Although bonds and stocks are two very different securities, they are related and can impact the performance of the other. Bond yields can influence the direction of the stock market, so investors should weigh their options when considering the impact of bond yields.
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