An effective investment plan allocates a portion of its assets to market-linked investment instruments, such as stocks and mutual funds, which have the highest return potential. However, as they come with higher associated risk, effective investment plans also ensure that they have investments in fixed-income instruments such as bonds and FDs, as they offer steady returns and lower associated risk. The combination of market-linked investment instruments and fixed-income instruments balances the overall portfolio due to ideal diversification. However, most investors think there is no correlation between bonds and the stock market, and neither is impacted by the other. In reality, bond yields have a close relationship with the stock market.

This blog will help you understand the relationship between bond yields and the stock market so that you can adjust your investments accordingly for the better returns.

• Bond yield is the return an investor earns from a bond, usually shown as a percentage.
• Bond yields impact stock prices as they can make stock investments attractive or less favourable.
• Understanding the relationship between bond yields and the stock market is vital to adjust investments accordingly.

Bonds are fixed-income instruments issued by governments and corporations to borrow from the general public in return for regular interest payments and the promise of principal repayment. Since you can sell the bonds at any time at the current market price, which varies from the par value of the bonds, the bond yield moves inversely to the bond prices. Bond yield is the measure of the total return you can get as an investor if you buy a specific bond and hold it until maturity. This means that the higher the bond yield, the higher the returns you will get from a bond. However, when the bond prices rise, bond yields fall as there are more bonds at the same price with a higher interest rate, which can offer better returns to investors.

Here is how bond yield impacts the stock market:

Cost of capital

The cost of capital (COC) is the rate of return a company requires to cover the opportunity cost of borrowing money through bonds. A higher cost of capital may reduce profitability and result in a slower expansion for a business, negatively impacting stock prices. When bond yields rise, interest rates often increase, making borrowing more expensive for companies and increasing their cost of capital. On the other hand, when bond yields fall, borrowing becomes cheaper for companies, lowering their cost of capital.

Opportunity cost

When bond yields rise above and showcase a return potential higher than stocks, investing in bonds becomes more attractive for investors than investing in stocks. The opportunity cost of holding stocks increases as investors could earn safer, guaranteed returns by investing in bonds. This leads to a sell-off in the stock market and higher investments in bonds. Conversely, when bond yields fall, the return on bonds becomes less attractive for investors, who look towards investing more in stocks. The opportunity cost of holding bonds rises, and investors may sell their bonds to invest the amount in stocks.

Foreign funds

Bond yields positively impact the amount of funds invested by foreign Institutional Investors (FIIs) in India. When bond yields rise in India, the higher return potential attracts foreign investors looking for higher returns on safer investments. They generally sell a portion of their investments and invest the amount in Indian bonds, especially in government bonds, which are considered the safest. This can lead to a decrease in foreign investment in stocks. On the other hand, when bond yields fall, the return bonds become less attractive to foreign investors, forcing them to shift their funds to higher-yielding assets like stocks or seek opportunities in other countries. This can increase foreign inflows into the stock market, boosting stock prices.

Bonds are among the most sought-after fixed-income instruments. They offer steady returns through interest payouts and the promise of principal repayment. On the other hand, stocks are market-linked instruments that offer higher returns but come with higher associated risk. As most investors add both instruments to their portfolios, it is important to understand how bond yields impact the stock market. Now that you know the relationship between bond yields and the stock market, you can better adjust your investments.