Bonds have had quite the start to 2021. With the sharp rise in yields, the debate about what it means for the rest of the market has heated up as well. So, to help shortcut some of the debate, I’m dusting off and updating my blog from the last time bond yields rose.
- There is strong empirical evidence that equities go up with rising yields
Looking back at the past four decades, we find 16 periods when Treasury yields went up sharply. In 14 of those episodes, the S&P 500 index went up too, on average by more than 7%. This time round has looked similar, with Treasury yields rising since August and the S&P 500 rallying sharply over the same period.
This doesn’t only hold for nominal yields: equities have risen in eight out of the past 10 periods of rising real yields.
- The driver of yields matters
More important than the direction of yields is why yields are moving. If yields are up because markets are pricing in stronger growth or declining deflation risk, then it’s good news for equities. If it’s hyperinflation worries, then it’s bad news.
So when thinking about the impact of rising yields on equities, always first ask ‘why are yields moving?’
- The speed of yield adjustment matters
Equities cope well with a slow rise in yields, but spikes – in either direction – are more problematic. Yield spikes raise the risk of dislocation in bond markets spilling over into other markets or the economy. As yields stabilise, equities typically recover.
- The level of yields matters
Price-to-earnings ratios have been highest when Treasury yields have been around 5-7%. Rising bond yields have historically become bad news for equities when nominal yields sit between 5-6%, and 2% in real terms. However, there are some reasons why the threshold could be somewhat lower this time.
- Equities have a valuation buffer against higher yields
Equities in aggregate yield more than government bonds. The yield gap is above average, as is the equity risk premium, but both have tended to increase with falling bond yields. Both should, and have, contracted with rising yields recently. Treasury yields of around 2.1% would only take the yield gap back to its long-term average, but only assuming earnings yields don’t also move.
- A small drag on earnings and buybacks
Higher bond yields hit earnings via higher interest expenses and lower GDP growth. We estimate that a 50 basis-point rise in corporate bond yields takes around 2% off S&P 500 earnings per share, a rounding error in the current environment of large earnings swings.
The incentive to buy back your own shares also erodes with higher corporate bond yields. For context, buybacks provided a steady 1.5-2% boost to S&P 500 earnings-per-share growth in the last cycle.
Can we condense all this even further into a conclusion? I would expect equities to continue going up with gradually rising bond yields, and see bond volatility-induced selloffs as opportunities to add to stocks.