Sensex crash and its correlation with bonds, stocks and the cost of leverage


With the exception of Nifty FMCG, all other sector indices closed in the negative, with Nifty Metals the hardest hit, falling more than 6%, followed by PSU banks, pharmaceutical, real estate and media companies.

On Wednesday, the United States Federal Open Market Committee (FOMC) announced that the Federal Reserve is unlikely to “decline” with the markets, which will lead to a liquidation of the global stock market on August 19.

Indian stock markets saw a significant correction on Friday August 20 after a steady two week gain as bears pulled it down amid a global sell off Thursday and Friday.

Earlier in the week, both the Sensex and the Nifty had reached their lifetime highs. On August 16, Sensex and Nifty finished at record highs for the third day in a row, thanks to gains in shares of Metals and Reliance Industries. The blue chip NSE Nifty 50 index ended up 0.21% to 16,563.05 and the benchmark S&P BSE Sensex index rose 0.26% to 55,582.58.

On Friday however, domestic stock markets closed with the BSE Sensex down 0.54% to 55,329 while the NSE Nifty closed lower at 16,450, recording a fall of 0.71%. Small and mid-cap indices also fell by more than 2% each. With the exception of Nifty FMCG, all other sector indices closed in the negative, with Nifty Metals the hardest hit, falling over 6%, followed by banks, pharmaceuticals, real estate and media.

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The United States Federal Open Market Committee (FOMC) on Wednesday announced that the Federal Reserve is unlikely to “decline” with the markets, causing the global stock market to liquidate on Thursday August 19th. However, as the Indian stock exchanges were closed on Thursday due to a local holiday, this sale did not affect the Sensex much. In fact, on Friday morning, NIFTY SGX Singapore futures reported a drop of nearly 200 points during the pre-open session. However, the gap has been closed and Indian markets have not fared as badly as their counterparts around the world.

The possibility that the US Fed’s stimulus measures will wane at the start of the year has indeed ended up scaring markets around the world, including India. In addition, a sharp increase in COVID cases around the world has added to the pressure.

Fed policymakers are far from united on the reasons for the bear’s return to equity markets. However, most financial experts attribute what is currently happening in the stock markets to liquidity.

How does liquidity affect equity markets?

For the first time ever, we are seeing widespread “negative yields” on several government bonds. An illustration of German government bond “yields” (see below) will help explain this point.

What the above data means is that if you had invested 100,000 euros in a 30-year German bond, the returns you get today are around 99,949 euros! In other words, you are actually paying the central bank to hold your money. While this was a common thing in markets like Japan, after COVID, with the support of the respective central banks, the trend has even spread to the West. Not only Germany, but also countries like Greece, Spain and Portugal were on the verge of defaulting on their bonds and are also having negative yields now.

A negative bond yield occurs when an investor receives less money at the bond’s maturity than the bond’s original purchase price. A negative bond yield is an unusual situation in which debt issuers are actually paid to borrow! Negative yielding bonds are bought as safe haven assets in times of turmoil and normally by investors such as pension funds, insurance companies and hedge fund managers in view of their required regulatory asset allocation. .

Many hedge funds and investment firms that manage mutual funds must meet certain liquidity requirements in their asset allocation. Asset allocation means that investments within the fund must have a portion allocated to bonds to help create a diversified portfolio. Allocating a portion of a portfolio to bonds is designed to reduce or hedge the risk of loss of other investments, such as stocks. As a result, these funds must hold bonds even if the financial performance is negative. Bonds are often used as collateral for funding and, therefore, should be held regardless of price or yield. However, in some cases, the purchase of these negative yielding bonds, especially by hedge fund managers, is also considered a “bet on the currency”. Some investors think they can still make money with negative returns. For example, foreign investors might believe that the currency’s exchange rate will rise, which would offset the negative bond yield.

Bond prices, interest rates and bond yields

Bond prices are inversely correlated with interest rates. As interest rates rise, bond prices fall. If rates fall, bond prices will rise. Bond prices are also inversely correlated with yields, so when prices rise, yields fall. There are many reasons that can influence bond markets around the world. Bond yields vary depending on a number of factors. Issuer credit quality, future expectations of interest rates and inflation, duration (the duration of bonds is a way of measuring how much bond prices are likely to change if and when In more technical terms, bond duration is a measure of interest rate (risk), bond type, and bid-ask spread over safer bonds like treasury bills… all matter. determine the yield.

Bond yields are an important determinant of equity valuations. Although there are exceptions, stock markets normally exhibit a negative correlation with bond yields. This means that when bond yields fall, stock markets tend to outperform with a larger margin, and as bond yields rise, stock markets tend to weaken. This relationship may not always be true, especially in the short term, but in general, it is the rule of thumb.

Opportunity cost of leverage and bond yields

The opportunity cost of capital is the amount of money lost by investing in one asset over another. As an investor, it may simply be choosing one asset over another. Bond yields therefore represent the opportunity cost of investing in equities. For example, on Friday August 20, the 10-year Indian government bond was yielding 6.23% per annum. This means that equity markets from a yield perspective will only be attractive if they can reasonably gain above 6.23% on an annualized basis. In fact, as equity is risky (we can have a capital drawdown if the market price drops below its purchase price) we first need a “risk premium” in order to be still comparable. Suppose the equity risk premium is 5%. Therefore, this 11.23% (5% + 6.23% will literally act as the opportunity cost for stocks (opportunity cost of leverage). Below 11.23%, it will not It does not make sense for the investor to take the risk of investing in stocks because even the risk is not compensated. The question of wealth creation does not start until later. Therefore, to create wealth. wealth, your wealth must be protected.As bond yields rise, the opportunity cost of investing in stocks increases and therefore stocks become less This is the primary reason for the negative relationship between bond yields and equity markets.

Global bond yields and inflow of FIIs in India

When Indian bond yields rise, global investors find Indian debt more attractive compared to global debt. This results in capital outflows from equities and inflows into debt. Foreign portfolio investment (REIT) views Indian stocks and debt as competing asset classes and allocates them based on relative returns. A rally in the stock market tends to increase returns as money moves from relatively safer investment betting to riskier stocks. However, if inflationary pressures start to build, investors tend to return to bond markets and get rid of stocks.

Disclosure: This revaluation does not constitute an offer to buy or sell securities. Investing in securities involves a risk of loss that clients should be prepared to bear.


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