The NYSE floor on a recent day. As bond yields soar, investors wonder when government bonds will be more attractive than stocks.
Credit to NYSE
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After a long hike in long-term government bond yields, the 30-year-old climbed just above 2% for the first time since Covid-19 hit. That has prompted investors when the broader trend of rising bond yields will hurt the stock market.
The central concern is that once government bond yields are high enough, investors will want to buy safe bonds instead of stocks or high-yield debt. But it’s not clear when that will happen, and the 30-year bond carries additional risk of losses as interest rates continue to rise. When it comes to the 10-year note, a more popular benchmark, Wall Street consensus is hard to come by: According to strategists’ projections, interest rates on 10-year Treasury bonds may only need to rise to 1.75%, or even 5%, to make them more attractive than those riskier alternatives.
Long-term Treasury yields have risen steadily since the end of August, and faster since November 9, when
Pfizer
and BioNTech have announced an effective Covid-19 vaccine. The 30-year yield hovered near 2% Monday after it crossed that level during morning trading – up from 1.6% before the vaccine. The 10-year yield benchmark is also up, rising from 0.8% before the vaccine to 1.2% Monday.
Long-term yields had slipped from their morning highs Monday afternoon due to concerns about Covid-19 vaccine distribution and the pace of global economic reopening, with 10-year yields one basis point (hundredth of a percentage point) and annual yield down three basis points.
But the expectation remains that yields will continue to increase in the coming weeks and months. And an important question is how high the revenues should be to lower the stock market return. Several Wall Street strategists have tackled that puzzle in recent notes.
Nearly 70% of S&P 500 companies pay higher returns than the 10-year note, a team led by stock strategist Savita Subramanian wrote in a recent note. That share would drop to 40% if companies keep their payouts at current levels and Treasury yields rise to 1.75% by the end of this year, they found.
That could undermine the attractiveness of stocks as an income game; today the total dividend yield on the S&P 500 is 1.5%, higher than the Treasury’s 10-year payout. That has helped alleviate concerns about valuations above the historical average.
Still, the picture looks much better for equities from a total return perspective. The implied long-term return of the S&P 500 is about 3%, the bank’s equity strategists wrote.
Wall Street strategists don’t expect the 10-year note to be able to challenge that return anytime soon. In a January Outlook piece,
bank of America‘s
Interest rate strategists predicted that 3% will be the peak of benchmark returns during this expansion, implying that returns will not reach those levels until the Fed starts raising interest rates. And according to some bank valuation models, all else being equal, stocks will look cheap compared to government bonds until interest rates rise to 5%.
More importantly, a 3% return on the S&P 500 will still exceed a major market measure of inflation expectations over the next decade. That indicator, called break-even inflation, was driven higher by improved growth expectations as the US recovers from the Covid-19 crisis. On Monday it hit 2.2%, the highest level since 2014.
In contrast, the yield on 10-year Treasury bonds remains below market inflation forecasts for the period and is expected to remain so at least through the end of this year. Even higher inflation-adjusted returns can’t hurt stocks, Credit Suisse strategist Jonathan Golub wrote in a Feb. 8 note, as the boost stocks get from stronger economic growth should offset the relative improvement in bond market returns.
Another positive for equities is that rising yields do not negatively impact the balance sheets of US large cap companies. The effective return of the ICE BofA Corporate Index, a measure of current financing costs for highly rated companies, remains only 1.9% for a term of nearly 12 years. And last year’s record flow of fixed-rate loans means companies won’t have to refinance their debt for years.
There is one way in which rising prices are negatively affecting at least some stocks: investors are less willing to wait for earnings growth,
Goldman Sachs
strategists wrote in a Feb. 7 note. Stocks prone to economic growth and “value” stocks that underperformed during the pandemic have fared better since the 10-year yield rose above 1%, they found, as investors discount future cash flows at a higher rate. The Russell 2000 Value ETF (IWN) is up 14% so far this year.
Goldman strategists wrote that a rapid jump in government bond yields would be dangerous for the stock market as a whole. But the bank estimated that real damage interest rates should rise 36 basis points in a month. That seems unlikely given that it took yields about three months to rise that far during the last striking move higher.
Of course, the rise in yields will likely require some changes in the way money managers who distribute cash across different markets make their decisions, strategists and investors say. Hedge fund DE Shaw recently discovered that long-term bonds should serve as a better hedge against stock market falls when interest rates rise.
Bonds are therefore likely to become slightly more attractive in the coming months. But it’s not clear whether such a shift will be enough to undermine equities, especially as long-term bond yields are most at risk from rising yields. So while government bonds could one day provide a better alternative to stocks, that process could take longer than investors might think.
Write to Alexandra Scaggs at [email protected]