Podcast & story | Sensex crash, its correlation with bonds, equities, leverage cost

Barring Nifty FMCG, all other sectoral indices closed in the negative with Nifty Metals being the worst hit, falling over 6 percent followed by PSU banks, pharma, real estate and media companies

On Wednesday, the Federal Open Market Committee (FOMC) of the United States announcement that the Federal Reserve is unlikely to ‘taper’ with markets any more, resulting in a global equity market sell off on August 19.

The Indian equity markets witnessed a significant correction on Friday (August 20) after a two-week consistent gain as the bears pulled it down amid a global sell-off on Thursday and Friday.

Earlier in the week, both the Sensex and the Nifty, had peaked to their lifetime highs. On August 16, Sensex and Nifty ended at record highs for third day in a row, driven by gains in metal stocks and Reliance Industries. The blue-chip NSE Nifty 50 index ended up 0.21% at 16,563.05 and the benchmark S&P BSE Sensex rose 0.26% to 55,582.58.

On Friday though, the domestic equity markets closed with the BSE Sensex down 0.54% at 55,329 while the NSE Nifty closed lower at 16,450, registering a fall of 0.71%.The small cap and mid cap indices too declined over 2 percent each. Barring Nifty FMCG, all other sectoral indices closed in the negative with Nifty Metals being the worst hit, falling over 6 percent followed by public sector unit (PSU) banks, pharma, real estate and media companies.

On Wednesday, the Federal Open Market Committee (FOMC) of the United States announcement that the Federal Reserve is unlikely to ‘taper’ with markets any more, resulting in a global equity market sell off on Thursday (August 19). However, since the Indian bourses were closed on Thursday due to a local holiday, this sell off did not affect the Sensex much. In fact, on Friday morning, the NIFTY SGX futures in Singapore signalled nearly 200 points slide in the pre-opening session. However, the gap got covered and the markets in India did not fare as badly as its peers around the globe.

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The possibility of the US Fed’s stimulus tapering early this year indeed ended up spooking markets across the globe, including India. Besides, a sharp rise in global COVID cases added to the pressure.

Fed policymakers are far from united on their reasons for the return of bears in the equity markets. Most financial experts, however, blame liquidity for what’s happening in the equity markets at present.

How is liquidity affecting the equity markets?

For the first time ever, we are seeing across the board ‘negative yields’ on several government bonds. An illustration of ‘yields’ on the German government bonds (see below) will help explain the point.

What the above data means is that if you had invested 100,000 Euros in a 30-year German bond, then the returns you get today is about 99,949 euros! In other words you are actually paying the central bank to hold your money. While this was a common thing in markets such as Japan, post-COVID, with support from respective central banks, the trend had spread to the West a decade back. Not just Germany, but countries like Greece, Spain and Portugal, which were close to default on their bonds just about a decade back are also on negative yields now.

A negative bond yield is when an investor receives less money at the bond’s maturity than the original purchase price for the bond. A negative bond yield is an unusual situation in which issuers of debt are in fact paid to borrow! Negative-yield bonds are purchased as safe haven assets in times of turmoil and normally by investors like pension funds, insurance companies and hedge fund managers towards their required regulatory asset allocation.

Many hedge funds and investment firms that manage mutual funds must meet certain liquidity requirements in their asset allocation. Asset allocation means that the investments within the fund must have a portion allocated to bonds to help create a diverse portfolio. Allocating a portion of a portfolio to bonds is designed to reduce or hedge the risk of loss from other investments, such as equities. As a result, these funds must own bonds, even if the financial return is negative. Bonds are often used to pledge as collateral for financing and as a result, need to be held regardless of their price or yield. However, in some cases, buying these negative yield bonds especially by hedge fund managers is also considered as a ‘currency bet’. Some investors believe they can still make money with negative yields. For example, foreign investors might believe the currency’s exchange rate will rise, which would offset the negative bond yield.

Bond prices, interest rates and bond yields

Bond prices correlate inversely to interest rates. As interest rates rise, bond prices decline. If rates decline, bond prices will increase. Bond prices also correlate inversely to yields, so as prices rise, yields go down. There are many reasons that could influence bond markets around the globe. The bond yields vary depending on a number of factors. Credit quality of the issuer, future expectations of interest rates and inflation, duration (bond duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, bond duration is measurement of interest rate risk), type of bond, and the bid-ask spread relative to safer bonds like treasuries…all matter in determining the yield.

Bond yields are an important determinant of equity valuations. While there are exceptions, the equity markets normally correlate negatively with bond yields. That means, as bond yields go down, the equity markets tend to outperform by a bigger margin and as bond yields go up equity markets tend to falter. This relationship may not always be true, especially in the short term, but in general, this is the rule of thumb.

Opportunity cost of leverage and bond yields

The opportunity cost of capital is the amount of money foregone by investing in one asset compared to another. As an investor, this can simply be a choice of one asset over another. Bond yields, therefore, represent the opportunity cost of investing in equities. For example, on Friday (August 20), the Government of India’s 10-year bond was yielding 6.23 % per annum. This means that the equity markets from a returns point of view will be attractive only if it can earn reasonably above 6.23% on an annualized basis. In fact, since equity is risky (one can have a drawdown in capital if the market price goes below one’s purchase price) there has to be a “risk premium” first of all, to be even comparable. Let us assume that the risk premium on equities is 5%. Therefore that 11.23% ( 5%+6.23% will literally act as the opportunity cost for equity(opportunity cost of leverage). Below 11.23%, it does not make sense for the investor to take the risk of investing in equities as even the additional risk is not being compensated for. The question of wealth creation only begins later. Therefore, in order to create wealth your wealth has to be protected. As bond yields go up, the opportunity cost of investing in equities goes up and therefore equities become less attractive and vice versa. That is the first reason that explains the negative relationship between bond yields and equity markets.

Global bond yields and FII inflows into India

When the bond yields in India go up, global investors find Indian debt more attractive in comparison to global debt. This leads to capital outflows from equities and inflows into debt. Foreign Portfolio Investments (FPIs) look at the Indian equity and debt as competing asset classes and allocate according to relative yields. A rally in the stock market tends to raise yields as money moves from the relatively safer investment bet to riskier equities. However, if the inflationary pressures begin to look up, investors tend to move back to bond markets and dump equities.

Disclosure: This write-up is not an offer to buy or sell any securities. Investing in securities involves risk of loss that clients should be prepared to bear.

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