Bond yields matter for equity investors

A rational investor intuitively demands higher returns to invest in an asset where the risk of loss is greater. Since government bonds are considered safe investments, their yields serve as a proxy for the minimum threshold for investment returns. Meanwhile, equities are considered risky, so investors typically demand a risk premium (i.e. additional return).

While the equity risk premium is not consistent between countries, nor constant over time, it generally ranges between 3 – 7%. If we assume that the risk premium on Australian equities is 5%, with the 10-year bond yielding 2.6% p.a., the domestic equity market is only attractive if investors earn the ‘hurdle rate’ of 7.6% p.a. or higher. However, as bond yields go up, the ‘hurdle rate’ for investing in equities also rises, so investors expect to pay less (i.e. buy shares at a lower P/E ratio) for the same shares, all else being equal.

Bond yields also impact valuation models, based on the time value of money concept. Essentially, these models value a company by discounting forecast future cash flows to the present value, using a discount rate that represents the required return investors expect. Once again, the bond yield normally serves as a proxy for the minimum risk-free return required, when calculating the discount rate. So when bond yields go up, the discount rate also goes up, reducing the present value of expected future cash flows and the company’s value.

While many factors affect equity markets, this highlights two reasons investors are concerned about spiking bond yields.

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