Make no mistake, rising bond yields are bad for assets
Right now, many investors are probably patting themselves on the back, having profited from a booming property market and the makings of a resurgent share market. But there is an elephant in the room – rising bond yields. And they could bring the party to an abrupt end.
Let’s take a quick look at the portfolio of a typical investor. There’ll be some shares for growth, some fixed interest, hybrids or infrastructure stocks for income and some property for diversification. So which of these are at risk from the rising bond yields we have been warning investors about all year?
The answer is: all of them!
Interest rates act like gravity on the value of assets. The higher the interest rates go, the greater the gravitational impact on asset prices. Irrespective of whether we are talking about bonds, shares, farmland or businesses, all assets are worth less when interest rates rise.
And bond rates are rising.
I have made this observation before but it remains a wonderful confirmation of the faddish nature of investor character; during the turn of the century tech boom, anyone investing in low-growth, high dividend yielding stocks, in boring industries such as infrastructure, were regarded as a boring has-been. In fact, in 1999 Warren Buffett was no longer described as the ‘Oracle of Omaha’, he was a pariah, like many who missed the tech boom. He had failed to see how the internet would change the world and was ‘washed up’.
In the most recent boom however it was precisely those same ‘washed up’ stocks that investors couldn’t get enough of. Forced by low returns on cash deposits investors stampeded into ‘higher’ yielding shares unwittingly taking on equity market risk for mere bond-like returns. But ignorance is bliss and the trend became self-reinforcing as rising share prices communicated to investors that they were ‘right’ – the upward price move was an affirming wind at investors’ backs.
As shares were pushed higher, by the baby-boomer-fuelled migration, the most expensive stocks became those of companies with the highest dividend payout ratios. Higher dividend payout ratios however mean lower retained earnings for growth. The most expensive companies then were those with the lowest self-funded growth.
Another group of companies that became expensive were those that the weighted average cost of capital calculation favoured. The formula valued most highly those companies that were 100% funded by debt. When low interest rates raise the values of companies with the most debt, something is seriously awry.
And so, since 2015 we have been warning investors that the chase for yield was a fad with dire consequences when the fashion changes. Low interest rates were corrupting their sense of risk and this was being reflected in the fact that the most expensive stocks were those with the most debt or the lowest growth.
Thank Donald Trump for the snap back to reality. Bond rates that were already rising since June spiked quickly, precisely as we warned. Back in 1994, bond rates rose 200 basis points in just a few weeks. Unsurprisingly, Sydney Airports – geographically located on a vacant block at the end of a global cul-de-sac – has been slammed. Transurban, the operator of the cul-de-sac, has also been slammed, REITs and utility stocks have also been hammered.
So where will it end? It won’t. Those commentators who believed low and even negative interest rates would stick around for a long time, labelling the era ‘the new normal’, were unwittingly succumbing to the same ‘this time is different’ groupthink that suckered in the technology investing bunnies of 1999 and 2000.
Debt is at record highs in Australia – not good as bond rates start to climb by the way! Mortgage debt as a percentage of both income and GDP is at a record, credit card debt is also at a record and government debt will also expand – as Colin Barnett in WA has found out over the last eight years with the debt in that state rising from $3.6 billion to $27 billion. And companies that borrowed heavily to buy back shares, pay special dividends or pay for overpriced acquisitions will find their profligate ways coming home to roost.
All this while aggregate P/E ratios for the ASX200-ex banks and the S&P500 remain at, or near, historic highs.
And whether they know it or not, ‘investors’ (I use the adjective loosely) who geared up to buy apartments for their kids amid a frenzy-inducing fear of missing out, are facing an abyss and are about to do their dough. I hope they don’t blame their kids. Make no mistake, rising bond yields are bad for assets.
And don’t take encouragement from the fact that stock markets have risen since Trump’s election. It has always been the case that during the early stages of rising interest rates, the stock market goes up. It does this because investors are buoyed by expectations of economic growth. History also shows us however that the enthusiasm ends as continued rising rates on bonds and cash become more attractive than riskier assets.
Our solution over the last six months has been to raise cash to take advantage of inevitably lower prices. We have also focused on companies able to grow their earnings. Rising interest rates will have a negative impact on the ‘P’ in the P/E ratio so you need a compensatory boost to the ‘E’ in the same ratio. And separately, we have also launched alternative funds such as a market-neutral and a long/short fund offering return profiles that are uncorrelated with the other asset classes. The timing is not coincidental.