Is it time to start worrying about rising bond yields?

Over recent months, US Treasury yields have been steadily climbing, and after hitting their highest levels in more than a year, markets are starting to become agitated by the move.

Since mid-February, we have seen a marked shift in sentiment towards high-growth stocks. This has been driven by the opportunity cost of what is effectively the risk-free rate of return across the market increasing, and in turn, drawing some investors out of the market.

However, for all the concern around the impact that rising bond yields might have, and what they tell us about future interest rate expectations, we believe the market is getting ahead of itself with its worries.

In fact, for the time being, we still believe this bull market has further potential to play out, with the growing number of stocks on ‘discount’ representing a great opportunity for us to take advantage of the volatility. What does the yield curve represent? Before we discuss our views on the matter, it’s worth briefly touching on the concept of the yield curve and bond yields.

The yield curve is used as a measure of future interest rate changes based on economic activity. It depicts the interest rates or yields of bonds that have different dates of maturity, but each have equal credit quality.

Market analysts and economists look to the slope of the yield curve to gauge expectations for how interest rates might change in the future.

Where the yield curve slopes upwards, higher interest rates are anticipated across financial markets in the future. On the other side of the equation, a yield curve sloping downwards suggests that the market expects lower interest rates moving forward.

In many respects, it is considered normal for the yield curve to represent higher bond yields that steadily increase until maturity, albeit flattening out where the maturity extends to long-term durations such as 10 years.

However, what we have seen more recently is a steepening yield curve on the back of concerns that excess inflation - largely attributed to massive fiscal stimulus - will force the Federal Reserve to raise interest rates far sooner-than-expected. The rotation from tech to value Investors typically look at companies through a series of lenses to work out their future growth prospects.

When interest rates rise, investors begin to adjust their valuation models for companies because of something called the discount rate. This is the rate with which investors value the future profits of a company.

As such, a steepening yield curve means the discount rate investors apply to their valuations also increases. The effect of this is lower valuations as the pendulum begins to swing more towards an emphasis on near-term profits as opposed to future (uncertain) profits.

Coupled with the fact that rising bond yields provide investors with an alternative asset choice, we can apply this logic to what we have seen occur over recent weeks. Investors have rotated out of high-growth stocks that are more reliant on future earnings growth to underpin their valuations.

Instead, investors have largely rotated into value stocks, where valuations are typically driven by a greater focus on near-term profits given their maturity.

This also explains why the tech-heavy Nasdaq entered a correction recently, while the Dow Jones hit a new all-time high - a dual-incident that hasn’t occurred in 20 years. At the same time, the more diverse S&P 500 has fared relatively well despite a large sell-off in certain growth names like Tesla (TSLA) and Apple (AAPL). Why yield concerns are overblown The first thing we should probably clarify is that rising bond yields have the potential to manifest as a problem for financial markets - even if largely sentiment-driven - except we do not believe we are near those levels yet.

Higher bond yields are ultimately a reflection that investors expect accommodative fiscal policy and stimulus to drive an improvement in the underlying strength of the economy.

Yes, here that ties in with expectations for higher inflation as well, however, bond yields have a poor history of predicting inflation. Even then, in an inflationary environment, there is still upside for corporate earnings, particularly companies not reliant on debt.

Concerns should be around disorderly inflation. Thus far, inflation isn’t coming in at nor looking like approaching the levels needed to prove concerning. If anything, it is still lagging expectations.

All the while, the volatility taking place is orderly when the economy is stitching together a post-recession recovery, let alone a recovery with the velocity with which we are witnessing.

Of course there is an expectation that this growth will slow once interest rates rise. But the Federal Reserve has continued to reassure investors it does not expect to reach that stage for a long time, and that it will keep interest rates low and continue purchasing assets until it hits its lofty goals.

More broadly, there is also the point to consider that stocks, particularly tech businesses, have fared well in high-yield environments, even times where the yield curve was steepening.

Since 1998, you could count on one hand the number of meaningful periods where real bond yields and stock prices had a negative correlation, with two of those instances being brief periods surrounding the early 2000s and Great Recession.

Where there has been a negative or inverse correlation, that relationship has typically developed when the 10-year Treasury yield hones in on 4%. Outside of these isolated periods, equity prices have largely enjoyed a positive correlation with rates. Perhaps even more surprising, the CBOE volatility ‘fear’ index (VIX) has been the one to display a negative correlation with rates.

To provide some further context, in 45 months over the last two decades where 10-year Treasury yields have surged by more than 15 basis points, the S&P 500 has delivered a negative return just 11 times. In fact, there is as much data over that timeframe showing a monthly drop of 3% or more in the S&P 500 when yields have been trending downwards - that is, 26 out of 31 times.

The market can of course get caught up in the fear and hysteria associated with a spike in Treasury yields. This happened in 2013 in an event dubbed the ‘Taper Tantrum’, when the Federal Reserve signalled it would begin slowly winding back its QE program. The rest is history as they say, but we’re not there yet.

What matters more to the stock market than bond yields is monetary policy. With this in mind, it is our view that an accommodative backstop is still in place and not disappearing any time soon.

A gradual-to-modest rise in bond yields is nothing bad in itself. It provides fund managers and investors the opportunity to rebalance their portfolios, plus allow stocks to find a more sustainable level of support. That’s why the steepening curve has caught some off-guard and led to a readjustment of positions that have put pressure on equity prices.

In the meantime, however, the companies we are backing or looking to add amid the volatility are those with either the financial standing, scale, efficiency or innovative capabilities to drive earnings growth in any fiscal environment.