Hi Sir,
I have a doubt on the inter relation between Equity – Bond – Yield.
When Interest rate goes up, people start selling equity and start buying bond their they will get higher yield.
This is quite confusing for me because as per my knowledge about bond, when Interest rate goes up, bond price goes down to adjust the price so that its yield match to the market interest rate and bond price going down because people are selling existing bond. This instance also give double effect to the liquidity in the market (i.e when interest rate goes up. People start selling both bond and the equity.)
I understand that the new bond, which is going to be issue, will offer current market yield only.
How the relationship i.e interest rate going up people will start selling equity and buy bond holds good ?
Your understanding is correct with respect to the bond price and interest rates. However, when interest rates rise and bond prices fall, then many investors want to invest at that low price.
It may be either because they want to benefit from the high-interest rates, or they expect the interest rates to fall again in the future and thus hope for capital appreciation too.
Moreover, while pricing equity securities, the required rate of return is the risk-free rate plus a risk premium. If market interest rates rise, the risk-free rate rises and so does the required rate of return. This decreases the intrinsic value of the stocks, and make many investments no more feasible due to the high required rates. Thus, they tend to move towards bonds tactically.
Another reason that an investor may want to move away from equity and into bonds is that if the high-interest rates seem to be persistent in the future, many capital budgeting opportunities of the companies, which had positive NPVs, may not remain profitable due to the higher cost of borrowing and higher cost of capital overall. This reduced growth expectations and future profitability.
That being said, there is no one-to-one relation between equity markets and the yields in practicality. There may be times where yields are falling and still people are investing in bonds and vice versa.
Hope this helps!