Market may fall further to compensate for sharp rise in bond yields

There has been a sharp decline in equity valuation in India in the past year, but foreign portfolio investors (FPIs) continue to be sellers on Dalal Street, thanks to an even bigger rise in bond yields in the US.

The benchmark BSE Sensex’s trailing price-to-earnings (P/E) multiple is down nearly 40 per cent, from a peak of 34.3x at the end of March 2021 to 21x on Thursday. This is the lowest valuation for the index in six years, excluding the Covid lockdown period in March-May 2020.

Analysts say equity valuation in India needs to fall another 20 per cent to compensate FPIs for the sharp rise in yield on risk-free US government bonds in the past two years. This could keep stock prices under pressure in India if bond yields in the US continue to stay high or rise further.

“As monetary tightening in the US gathers pace and bond yields rise, yields have to rise in all asset markets to align with the changes in the bond market. This will translate into further correction in equity prices,” says Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity. He expects a synchronous deflation in asset prices across the globe due to sharp rise in the cost of capital.

The equity and the bond market are joined at the hip through respective yields on both instruments. For bond yields are annual interest that bond holders receive. In the case of equity, earnings yield is the expected dividend yield for an investor if the company/index distributes 100 per cent of its annual net profit as equity dividend to shareholders.

Earnings yield is inverse of a stock P/E multiple and it rises as valuation declines and vice versa. Earnings yield is most often higher than the yield or interest on risk-free bonds to compensate investors for the risk involved in equity investing. When yields on government bonds rise, equity investors have to compensate with a matching rise in earnings yield or a decline in stock valuation.

The Sensex had an earnings yield of 4.76 per cent on Thursday, given its P/E of 21x, compared to the US 10-year bond yield of 3.48 per cent. This translated into a yield spread of 1.29 per cent, or 129 basis points (bps).  

The yield on the benchmark 10-year US government bond is up 295 bps, or 559 per cent from its record low of 0.53 per cent in July 2020. The 10-year US treasury was trading with a yield of 3.48 per cent on Thursday, highest since April 2010 (on monthly closing basis) and up nearly 200 bps since the beginning of the current calendar year.

As a result, the spread between the Sensex earnings yield and the 10-year US treasury yield declined to 129 bps on Thursday, compared with 208 bps at the beginning of the current calendar year and a high of 469 bps in April 2020.

The current yield spread is nearly 100 bps lower than the post-Lehman crisis median spread of 230 bps. To get to the median yield spread of 230 bps, Sensex P/E multiple needs to decline to 17x, nearly 21 per cent lower than the index current P/E multiple of 21x. 

The index earnings yield can also rise due to expected growth in the combined earnings of the Sensex companies in the forthcoming quarters. However, this looks tough, given the global and domestic headwinds. Indian companies also face downside risk from a potential depreciation in the rupee from current levels.