Why bond yields are so important to stock markets

The 2-year gilt is warning of possible interest rate increases, while the 10-year gilt yield now exceeds the FTSE 100 dividend yield by more than one-and-a-half percentage points. Both are factors which help to explain the FTSE 100’s retreat from its February all-time high.

The 2-year gilt yield is seen as a summary of financial markets’ views as to where the Bank of England base rate may go next. But from an investment point of view, it is the yield on the 10-year issue that really matters.  

Higher interest rates and bond yields in themselves do not necessarily spell the end of an equity bull run, but in the end, weight stops trains and racehorses and higher returns on cash and fixed-income securities slow down stock markets – it is a matter of degree.

The FTSE 100 has done a good job of sweeping aside increases in the Bank of England base rate. In some ways, the increases were welcome as they signalled a normalisation of policy.  

But March’s surge in oil and gas prices after the start of the war in the Middle East has sparked concerns that a sustained increase in the cost of hydrocarbons could either slow the economy, stoke inflation or both.  

As a result, the 2-year gilt yield now comfortably exceeds the Bank of England base rate. Meanwhile, the 10-year yield is hovering near the 5.00% mark for only the third time since 2008.

The test now is whether higher yields on government bonds tempt portfolio builders to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly.

Three effects of higher bond yields

Higher bond yields have several possible implications for equity holders.  

1. Higher interest rates as a result of higher oil and gas prices could dampen economic growth and hit near-term corporate earnings.
2. Higher interest rates and bond yields eventually feed into higher mortgage rates, and again potentially crimp consumers’ willingness and ability to spend and thus near-term economic growth.
3. Increased bond yields can lessen the relative attraction of equities compared to fixed income as a source of yield.  

The risk-free rate

The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because the Government is unlikely to not pay its lenders back.  

Bear in mind that the yield on the bond will differ from the coupon, or interest rate, at its time of issue. This is because the bond’s price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss on after the purchase of the bond since it will usually be redeemed upon maturity at its issue price.

The 10-year gilt is yielding 4.91%. This is therefore the minimum nominal return on any investment that investors will likely accept, since it is seen as risk-free (despite the tiny chance the UK does default).  

Any other alternative investment carries more risk so the investor should demand more from them. For example, investment-grade corporate bonds should yield more than government bonds because companies can and do go bankrupt.  

The returns demanded by an investor to compensate themselves for the risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates. For shares, it means paying a lower valuation, and perhaps demanding a higher dividend yield.  

Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth.  

Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis.