Having worked as an equity strategist for well over a decade, I’ve lost count of the number of times I’ve had the debate on ‘what happens to equities when bond yields go up?’. And for most of that time bond yields were in the ice age and falling! To cut down on some future deja-vu, here's my Top 7 list of things to consider about equities when bond yields go up.
1. There is strong empirical evidence that equities can go up with rising yields
Looking back at the last four decades, we find 16 periods where Treasury yields went up sharply. In 14 of those episodes the S&P went up, on average, by more than 7%.
- The driver of yield 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 normally good news for equities. If it’s hyperinflation worries, then it’s bad news.
- The speed of yield adjustment matters
Equities usually cope well with a slow rise in yields, but sharp yield moves, in either direction, are typically more problematic. Yield spikes raise the risk of dislocation in bond markets spilling over into other markets or economy. As yields stabilise, equities typically recover.
- The level of yields matters
Price-earnings (PE) ratios have generally been highest with 10-year Treasury yields at 5-7%.
Rising bond yields have become bad news for equities at 5-6%. However, there are some signs it could be earlier this time.
- Equities have a valuation buffer against higher yields
Equities usually yield more than bonds. The yield gap is currently above average, as is the equity risk premium (ERP), which is the return premium that investors typically demand for holding equities over bonds. The yield gap and ERP have generally increased with falling bond yields. Both should, and have, contracted with rising yields. Treasury yields around 3.6% would take the yield gap back to its long-term average.
- A small drag on earnings
Higher bond yields hit earnings via higher interest expenses and lower GDP growth. We estimate that a 0.5% rise in corporate bond yield takes ~2% off S&P 500 earning per share (EPS).
- A small drag on buybacks
The incentive for buying back your own shares erodes with higher corporate bond yields. Buybacks stop being earnings accretive when bond yields rise above the earnings yield (currently ~5.8%). Buybacks have been a steady 1.5-2% boost to S&P EPS growth.
So can we condense all this even further into a conclusion? I would expect equities to continue going up with gradually rising bond yields, although the trade-off starts to get more complicated when Treasury yields reach the 3.5% to 4% range.