The recent stock market fallout has resulted in investors moving out of stock markets and venturing into safer territory like the debt market.

If as an investor you are considering investing in the bond market with the belief that the stock market and the bond market always move in opposite direction, then think twice. Its true that there is a linkage between stock markets and bond markets, but remember that both these markets do not always move in the opposite direction in terms of returns.

Lets see how
Consider, for instance what happens when the Reserve Bank of India (RBI) cuts the interest rate. We all know the yield for the bond depends upon the coupon offered, market price of the bond and the time for which the bond is held. When RBI announces the rate cut, the bond price surges as there is more demand for the instrument because the coupon on the bond is higher than the market interest rate after the rate cut. The interest rate and bond yields are inversely proportional (move in the opposite direction) i.e. when interest rates are cut bond yields rise as bond prices appreciate. Higher yield results in a surge in demand for bonds and this pushes prices up even further.

Now lets see the impact of a rate cut on the stock market. A cut in the interest rates means cost of fund for the companies’ decreases enabling them to borrow at a lower rate. This prompts companies to go in for expansion and diversification to boost profits. Increased profits means better earnings per share (EPS), which translates into higher stock prices. Of course, all this will happen over a period of time.

The bottom line is that a cut in interest rates could push up bond and stock markets. By the same measure, a rise in interest rates could pull down both the markets but not necessarily with the same intensity.

It is a well-known fact that the bond market is driven by economic factors, such as forex reserves, trade deficit and inflation, which might not be of much concern to the domestic equity investors and the stock market may not be affected.

At the same time, a profit warning by a sector specific company may have an negative impact on other companies in the same sector there by pulling down the equity market, but the bond market may remain unaffected by the event.

So, one need’s to understand that the factors affecting the two markets are very different and its not always that bond and stock markets move in opposite directions. There are specific factors that have an impact on the two markets and one needs to understand and analyse those factors before investing in either of these markets. But nevertheless the bond market is much safer to invest in, (less volatile) as compared to the equity market.

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