Govt. Bonds v/s Equity – Where to Invest?

In a rising interest rate environment, the bond yields go up, while bond prices fall. For example, if you buy a bond at a coupon rate of 10% at a par value of Rs 1000, the yield would be Rs 10 per cent. But if the price of the bond goes down to Rs 800, the yield of the bond will rise to 12.50%. This would also work vice-versa – if the price goes to Rs 1200, the yield will fall to 8.33%. In all the 3 cases, an investor will get a cash flow of Rs 100. 

The bond market is in the news of late, as the 10 Year Bond yield was shooting up, trading around 9%. In the last one month, however, it has come down by approximately 50 bps on the back of Open Market Operations (OMOs) conducted by the RBI. It is currently trading at Rs 102.08, with a yield of 8.47%. The 10 Year Govt. Bond is one of the leading indicators that can decide the health of the economy. Now, the million dollar question is why is there such movement in the yield?

One of the major reasons for the bond yield rising is the RBI's hawkish monetary stance. The central bank has hiked interest rates (repo) 13 times since March 2011, which is why we are seeing a sharp rise in the bond yield. This rise is not good for the economy, as the cost of borrowing rises for the govt.

There is an interesting concept called Bond Equity Earning Yield Ratio or BEER. This is used to evaluate the relationship between the bond yield and the earning yield of the stock market. The calculation of this is: BEER =  Bond Yield/Earning Yield of the Equity Market. In case of bond yield, we take the 10-Year Government bond, which is 8.47%. The trailing earnings of the Sensex is Rs 940, and with the Sensex currently trading at levels of 16000, its earnings yield would be 5.88% (940/16000). Therefore, the BEER ratio stands at (8.47/5.88), i.e. 1.44. A BEER ratio higher than 1 indicates that the Sensex is overvalued, or that the bond yield is not adequately priced.

The following table shows the sensitive analysis of the BEER ratio. At various levels of the Sensex, we get a different earning yield, which is then compared with the bond yield. The shaded area is the position where we stand today. So, for the BEER ratio to come close to 1, either the bond yield should improve or the markets could take a correction. Also, an increase in earnings (Sensex) could help, but in an uncertain environment, that seems unlikely.

                                                                                  Bond Equity Earning Yield Ratio (BEER)

In an uncertain macro environment, investors prefer to invest in fixed income securities and would stay away from the equity market. Fixed income instruments like bonds (govt. as well as company), fixed deposits, debentures etc. form a worthy investment asset class, as they yield decent returns with very low risks. We believe that investing in bonds will not only keep investors away from the turbulent equity market, but they would also be benefited in the long run. As and when the bond yield starts reversing, the price of the bonds will start moving northwards and investors will stand to gain.