Risk-reward for investing in equity gets a boost

Spread between earnings yield and bold yield lowest since 2013; dividend yield and bond yield lowest since 2008.

Illustration: Uttam Ghosh/Rediff.com.

The risk-reward ratio for investing in equities has turned favourable, following the recent correction in stock prices and softening of bond yields. The spread between earnings yield and the 10-year government security (G-Sec) has dropped to the lowest level since July 2013, while that between dividend yield and G-Sec yields touched the lowest level since December 2008. 

These ratios indicate the perceived risk differential between equity and bonds. Whenever earnings yield and bond yield spreads fall below one, equities are considered to be undervalued. Similarly, the lower the spread between dividend yield and bond yield, the lower is the risk of investing in stock markets. 

However, this ratio is not as widely followed as earnings yield to bond yield, as company policies might impact dividend payouts. Earnings yield and bond yield recently fell to as low as 0.52 per cent, after yields on the 10-year G-Sec fell to as low as 6.18 per cent and Sensex earnings yield stood at 5.66 per cent. In other words, every Rs 100 invested in bonds would earn a coupon of Rs 6.18, while the same amount invested in company scrip would earn Rs 5.66.

This was following a surprise demonetisation announcement 10-year G-Sec yields came from 6.84 during the start of November to a low of 6.18 on November 24. Benchmark Sensex came off by as much as 10 per cent during the same period, improving the earnings yield -- which is earnings per share dividend by share price.

“The ratio is currently low, which indicates equities are relatively more attractive to bonds. When you invest in bonds, the coupon is more or less constant. Earnings of a company can go upwards, given that earnings estimates are already low,” said Ravi Muthukrishnan, co-head of research at ICICI Securities. Interestingly, the improvement in the ratio has been purely on the back of fall in yields and not due to improvement in earnings outlook. On the other hand, earnings yield has, in fact, dropped from a high of 6.5 per cent at the start of the financial year.

Earnings growth for the current financial year has been scaled back due to demonetisation. Analysts now expect 2016-17 earnings to grow just five per cent, compared to earlier expectations of 12-15 per cent. However, earnings growth estimates for Sensex for the next financial year remains high at 15-18 per cent. Higher earnings growth could translate into higher earnings yield and improve attractiveness of equities, if bond yields remain constant. 

Morgan Stanley says Indian equities could deliver 15 per cent returns in 2017, compared to flattish returns in 2015 and 2016. “Equity valuations relative to bonds best since the global financial crisis. India is one of our top emerging market picks,” said Ridham Desai, equity strategist at Morgan Stanley in a recent note.

Muthukrishnan said the diminishing outlook for other asset classes would work in favour of equities.

“A 10-15 per cent return on equity investment is attractive, as other asset classes such as gold and real estate are not doing too well,” said Muthukrishnan.