Why rising bond rates may be a threat to stocks

This is one of those times that investments have crossed the Rubicon, with Treasury notes paying better than stocks. It’s normally the other way around. If that situation remains, the fear is this could act as a brake on stocks, holding them to low-single-digit growth or even booking losses.

The usual pattern, in which the benchmark 10-year Treasury yields less than the S&P 500, occurs because government bonds aren’t as risky as stocks. Treasury paper has the full, taxpayer-backed power of the federal government behind it, and missing a Treasury interest payment is almost unthinkable. So Washington doesn’t have to pay you as much as stock-issuing companies do.

Stocks are riskier -- they fell almost 40 percent in the 2008 financial crisis. Plus, they have no obligation to pay dividends to investors, and companies can lower or eliminate them at will. (Yield is determined by dividing bond interest or stock dividends by the securities’ underlying price.)

With bonds, known as fixed-income investments, giving investors so little interest post-crisis, people piled into stocks for better income streams. Some stocks generated very sweet yields, over 5 percent.  

Now the 10-year U.S. Treasury note is at 2.4 percent, having risen a full percentage point since last year, while the S&P 500’s dividend yield is at 1.9 percent, around where it has been stalled for some time. 

Rising bonds rates most heavily affect the so-called defensive sectors, such as consumer staples and utilities, which classically have sluggish share price appreciation but lush dividend yields. As financial website Motley Fool observed, “stocks in low-growth industries also often fall in rising-rate environments.” 

Look at the iShares Select Dividend (DVY) exchange-traded fund, which is heavy on utility stocks. So far this year, it’s up just 2.25 percent. The S&P 500 has risen by almost 6 percent.

In a research paper, Goldman Sachs analysts warned that ever-higher bond yields could render stocks particularly vulnerable, should a war or some other unexpected event roil the market. In that case, investors might sell stocks in a panic to crowd into the safety of bonds, made even more enticing by their lofty yields. 

“Higher bond yields are likely to weigh on equities and reduce their buffer for shocks,” the firm cautioned.

Certainly, it takes a much wider gap than the current half-percentage point between the 10-year-note’s 2.4 percent yield and the S&P 500’s 1.9 percent to harm stock prices noticeably. Since 1953, according to research firm CFRA, whenever the 10-year Treasury yield exceeded the S&P’s by less than a full percentage point, the stock market rose an average 11 percent in the next 12 months. 

Yet as the gap widened in the bond’s favor, CFRA calculated, the equities market gained less and less. When the 10-year out-yielded the S&P by 2 to 3 points, the index advanced just 3 percent, and when the gap was 3 to 4 points, the S&P increased a mere 1 percent.  

For much of the eight years since the financial crisis, the 10-year and many other government debt instruments were in their customary position, yielding less than stocks. But an additional influence weighed down their yields even more than usual: the Federal Reserve. 

Since 2008 until lately, the Fed has striven to keep bond rates low in a bid to stimulate the shell-shocked U.S. economy, an approach known as zero interest rate policy, or ZIRP. During the ZIRP era, investors piled into stocks for income because government bonds paid so little. Of the 500 stocks in the S&P’s mainstay index, 85 percent pay dividends. 

Now, though, with the economy showing more life, the Fed has started to push up short-term rates, which usually translates over time to higher long-term yields. So in recent months, the trend to chase income in stocks has been reversed: Amid the Fed’s hikes and somewhat higher inflation, due to the better economy, the benchmark Treasury has out-yielded the broad market index since late last year -- with every sign that the pattern will continue.

And another factor is at work here: the stagnant level of the S&P 500 yield, which has been stuck at around 2 percent for a while. A big part of that is the high valuations of stocks these days, said Stephen Wood, chief market strategist at Russell Investments. “Equities are expensive,” he said. “Rising fixed-income interest makes bonds competitive with stocks.”

Even before the so-called Trump Bump, which started with last fall’s election results, stocks have risen smartly for years, in part because bonds offered so little in terms of payouts. The S&P 500 index today has a price/earnings ratio of 24, which is far higher than the historical average of around 15. 

All that said, good dividend-paying stocks are still available. Bill Gunderson, head of Gunderson Capital Management, noted that defense contractor Lockheed Martin (LMT) should do well during the planned Trump military buildup. Over the past 12 months, the stock is up 24 percent, and it yields 2.7 percent. “In my opinion, there’s much more upside potential than a bond has to offer,” he wrote.

The scourge of bonds, of course, is inflation. Bond prices seldom appreciate the way stocks can, doubling or tripling. For that reason, stocks are a better holding to withstand inflation, now running at around 2 percent.

“If a bond yields 4 percent or even 5 percent, it still doesn’t have the natural inflation protection of a stock,” said Jared Hoff, a portfolio manager at the Federated Global Strategic Value Dividend (GVDSX) fund.  

Also, it’s important to realize that both dividend yields and interest rates are at exceptionally low levels. The Fed is seeking to “normalize” rates, meaning it’s trying to take them back to where they’ve been historically. So buying a bond now will lock you into a low rate.

The current superior yield of the 10-year T-note “does take away from some of the allure of dividend stocks,” said Greg McBride, chief financial analyst at Bankrate.com. “But if you buy a 10-year Treasury, then 2.4 percent is all you’re going to get for a decade.”