Rising Bond Yield and PE contraction

Its theory personified! Bond Yield has shot upto 9.25% and market is expecting that it will peak at 10.25%-10.5% should inflation go sky high to 15-17%. On the contrary, taking consensus FY09E EPS of INR 1050 (growth of around 18-19% still!) takes forward PE to around 14.5x. The reciprocal of forward PE (thus Earning Yield), comes at around 7% as against Bond Yield of 9.5%. A rational investor usually compares bond yield with earning yield to make a risk-reward trade off as bond carries lower or no risk (though inflation poses risk to bonds, but equally to equities too). Rising bond yield increases the cost of equity (and thereby increases the required return on equity investment by investors) thus decreases the value of equity hence leads to PE contraction.

Though historically in India and even in the US, investors do not mind having lesser earning yield than bond yield, as they have growth expectation from equities which is not there in case of bonds. But the increasing gap (given higher inflationary concern) between bond yield and earning yield gives smoke signal. Hence inflation and growth concern can lead investor to re-think on gap between bond and earning yield.

Inflation, which is already running at 13 years high is further expected to go up to 15% in next 1-2 months, thus the bond yield would further increase as RBI will further tighten the monetary policy.

There is one more risk which is publicly acknowledged but still not been quantified yet! The EPS forecast of INR 1050 assumes FY09 EPS growth of around 18-19% Y-o-Y. We have heard enough of earning slowdown and downgrades however very few prominent brokerage houses have reduced their FY09 EPS growth forecast and the consensus still see growth of 18-19%. Should the growth comes down to 15%, the expected FY09 EPS would come in at INR 975 thus increasing the FY09 PE to 15.5-16x and thereby further reducing the earning yield to 6.0-6.5%, hence further increasing the bond yield and earning yield gap.

Better than expected Q1 FY09 earning growth (with few exceptions), lower oil prices and stable food prices gives us some sort of comfort, however given bleak mid term macro picture the short term positive movement (typically called as bear market rallies) should be taken as an exit opportunity to re- enter the market at lower level.