Why Rising Bond Yields Could Put Pressure on Australian Shares
Higher interest rates can reduce the present value of future company earnings, while making bonds relatively more attractive to investors
Rising bond yields can create pressure for share prices because they influence the way investors and fund managers value future corporate earnings, dividends and other cash flows. When government bond yields increase, the rate used to discount future company cash flows also tends to rise, which can reduce the present value investors place on those future returns.
At the same time, higher bond yields can change the relative appeal of investing in shares compared with fixed-income assets. This relationship has become particularly important as bond yields have moved higher across major markets and investors reassess the outlook for interest rates.
Why higher yields can reduce share valuations
The basic principle is that the current value of a company's shares reflects the value of the cash it is expected to generate in the future. Those future earnings, dividends and buybacks are discounted back to today's value using an interest or discount rate.
When interest rates rise, the discount rate also tends to increase. Assuming everything else remains unchanged, a higher discount rate means future cash flows are worth less in today's terms. That can put downward pressure on share valuations.
The effect can be particularly noticeable for companies where a larger proportion of their expected value is based on earnings that are further into the future. When market interest rates increase, investors may therefore reassess how much they are willing to pay for those future earnings.
Bonds become more competitive with shares
Higher interest rates can also change the opportunity cost of holding equities. When bond yields are very low, investors may be more willing to hold shares because there is less income available from relatively lower-risk assets.
As bond yields rise, however, investors can potentially earn a higher income from government and other fixed-income securities. This can make the relative appeal of shares less compelling, particularly for investors focused on income.
That does not mean rising rates automatically lead to falling share prices. The relationship depends heavily on what is happening to economic growth and company earnings at the same time.
Why rising rates do not always hurt shares
Historically, share markets have often risen during periods of increasing interest rates. One reason is that central banks may raise rates because economic growth and corporate earnings are improving.
When stronger earnings expectations more than offset the impact of a higher discount rate, share prices can continue to rise. The relationship becomes more challenging when rates are increasing because inflation is persistent while economic growth is weakening.
That is the scenario currently drawing attention in Australia and other advanced economies, where investors are watching whether higher borrowing costs can reduce inflation without causing a significant slowdown in economic activity.
What it means for investors
For investors, rising bond yields are therefore important not simply because they make borrowing more expensive, but because they can influence share valuations, income preferences and expectations for future earnings.
The key factor to watch is the reason behind the rise in yields. If yields increase alongside stronger economic and earnings growth, equities may remain resilient. If yields rise because of persistent inflation while growth weakens, pressure on share valuations could become more significant.
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