This Indicator Suggests That Bonds Are More Attractive Than Equities

The sharp rise in bond yields over the past few months has made existing fixed income investors nervous. But the fall in bond prices and the consequent rise in yields, may have made fixed income a more attractive asset class compared to equities. Particularly, since the earnings yield of NSE 500 companies is actually falling.

Earnings yield is the net profit for the trailing 12-month period, divided by market capitalization. In other words, it is the inverse of the price-to-earnings multiple. It reflects the total yield to an investor if the company distributes its entire annual profit as dividend.

Historically, or atleast over the last seven years since the Lehman Crisis, the earnings yield of NSE 500 companies and domestic bond yields have moved in the same direction. This trend has now broken.

Over the past two months, bond yields have risen but earnings yields have fallen further.

The yield on the 10-year government yield is currently at close to 7.4 percent, up from 6.5 percent at the end of December 2016. Over this period, the NSE 500 earnings yield has declined to a decade low of 3.5 percent from 4.3 percent a year ago.

There are two ways to interpret this - that equities are overvalued or bonds are cheap. Either ways, investment professionals say that the divergence between bond yields and earnings yield has increased the relative attractiveness of debt.

“Currently equity markets have become expensive and debt has become significantly cheaper and there is more value in debt as compared to an year ago,'' said R. Sivakumar, head of fixed income at Axis Mutual Fund. He added that this gives investors a good opportunity to enter the debt markets.

The yield on the benchmark 10-year Indian government bond rose 66 basis points in the September-December quarter. Yields jumped as markets factored in higher government borrowings and the possibility of rising inflation. Selling from domestic banks, who were sitting on excess bond holdings, also led to a further fall in prices and a spike in yields.

In contrast, the equity markets chose to focus on strong inflows from domestic investors and the expectation of a pick-up in the economy and earnings growth during the next fiscal.

The result - a nervous bond market but a confident equity market.

Investors, however, may be better off if they look beyond sentiment and pick bonds over equities since a number of macro uncertainties are already priced in there, said Kumaresh Ramakrishnan, Head – Fixed Income, DHFL Pramerica Asset Managers Pvt. Ltd.

Equity market veterans explain that one reason for the recent divergence has been the breakdown in correlation between global growth and domestic growth. While the global economy saw one of its best growth years in 2017, the Indian economy sputtered due to the twin shocks of demonetisation and the implementation of GST.

According to the IMF's October World Economic Outlook, the global economy is seeing growing by 3.7 percent in 2017 and 3.8 percent in 2018. The Indian economy is forecast to grow by 6.7 percent in 2017 and 7.4 percent in 2018.

“This explains the widening gap between bond yields and earnings yields,” said G Chokkalingam, managing director of Equinomics Research & Advisory.