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This is Part 1 of our series on rising govt bond yields.

In Part 2, we look at the impact of rising yields on the S-REIT sector in particular (and highlight which S-REITs analysts most bullish about at current prices).

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Article Summary

1) Are rising yields good/bad for stocks? It depends.

2) Rising yields are good for stock markets, if two criteria are met

3) Instances of short-term yield spikes in the past two decades

4) Stock sectors that perform best to worst during yield spikes

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The InvestQuest View

Rising bond yields are generally positive for stock markets if, 1) the rate of increase is gradual and orderly and, 2) it is rising from a low base. With the recent spike in 10-year UST yields coming in close to the largest short-term yield moves in the past two decades, we are optimistic that rate volatility should subside soon. As such, we are taking a “buy the dip” mentality. We’ll be focusing on some of the mega caps within the tech sector, given that the recent sell-off has been more severe for growth stocks.

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1) Are rising yields good/bad for stocks? It depends.

Theoretically, rising yields are bad for stocks

Typically, rising government yields are considered negative for stocks because of two reasons.

1. Higher interest expenses might negatively impact corporate earnings.
2. Investors “demand” higher stock returns given that the risk-free rate is now higher.
   • For all stocks, investors should apply a higher discount rate (i.e. lower stock price target).
   • For dividend yielding stocks, investors should now “demand” a higher dividend yield than before (i.e. lower stock price target)

The higher discount rate is especially significant for growth stocks. This is because for growth companies, a big chunk of the value is expected to be realized only in 5 to 10 years time. So when investors apply a higher discount rate, this has a disproportionately large impact on growth stocks.

That’s why in the recent pull-back, tech stocks underperformed the broader market.

Yields have actually been rising since Aug 2020, but market pulled back only recently!

But let’s take a look at a longer time frame (since start of 2020). Yields have been rising since Aug 2020, but the markets have only pulled back recently! See chart below.

Conclusion: There’s more than meets the eye

Conclusion: Rising yields in itself isn’t necessarily a bad thing for stocks. See the next section for more detail.

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2) Rising yields are actually good for stock markets, if two criteria are met

Criteria 1: Yields are rising from a low base

Criteria 1: Rising yields are good for the stock markets if yields are rising from a low base. We should differentiate if yields are rising from a low base or high base. Yields rising from a low base is often related to a buildup in economic growth expectations (and positive for stock returns), while yields rising from a high base could be linked to inflation concerns (and negative for stock returns).

Evidence: Here’s correlation between the S&P 500 vs 10-Year US Treasury yields, based on data from May 1963 to May 2019 (below chart). The chart shows that:

• When yields were low (<5%): Stock returns were positively correlated to rising 10-year UST yields .
• When yields were high (5% and higher): Stock returns were negatively correlated to rising 10-year UST yields

Right now, UST yields are still very low at 1.4% (green line), even after the recent spike. This makes us optimistic that rising yields aren’t going to break the stock market.

Criteria 2: Pace of yield increase is expected

Criteria 2: Rising yields are good for the stock markets if the pace of yield increase is widely expected. A rise in govt bond yields has been a consensus view among investors this year, so the recent increase in UST yields itself shouldn’t have come as a shock to anyone. What has spooked risk assets (particular tech-related stocks) in the past two weeks perhaps has more to do with the pace in the rise of govt bond yields (and the volatility spike within the treasury market).

In the below chart, we overlaid the implied volatility of US Treasuries (red line, using the MOVE Index as a proxy), against the implied volatility of the S&P 500 (black line, using VIX Index as a proxy).

We can see that they move in tandem.

What to look out for: So, it’s important to watch closely for whether the MOVE Index retraces back down in the days ahead, as it may provide an indication on whether the tech sell-off may be receding.

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3) Instances of short-term yield spikes in the past two decades

In the chart below, we plotted the 10-year UST yields since 2001, compiling the dates where there had been a short-term spike in UST yields (circled in red).

No one knows for sure if US Treasury yields will continue rising. However, the magnitude of the recent yield spike is closing in to the largest spikes seen in the last 20 years, so we remain optimistic that rate volatility should subside soon and are adopting a “buy the dip” mentality (particularly for some of the mega caps within the tech sector).

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4) Sectors that perform best to worst during yield spikes

We would have guessed that stock market returns would be weak during periods of yield spikes…but this has not been true historically.

Below, we’ve taken a look at how individual sectors did during previous yield spikes.

Our intention is to see if there are opportunities to add to individual sectors that have done well in the past instances but are not doing so well in the current episode, and vice versa.

Performance of various S&P 500 sectors during short-term yield spikes

In the below table, we have compiled the total return of the S&P 500 during short-term yield spikes (dates mentioned earlier). The S&P 500 had delivered positive returns in each of these instances, with an average return of 7.4% over an average holding period of just over 4 months.

What history tells us: Best & Worst performing sectors during short-term yield spikes

In the table, we ranked the S&P stock sectors in descending order of performance during past short-term yield spikes (rightmost column in above table).

• Sectors that are currently doing relatively better compared to past instances of yield spikes are Communication Services, Industrials, Energy, Financials.
• Sectors that are currently doing relatively worse compared to past instances of yield spikes are Information Technology and Consumer Discretionary.

Exception this time around

Communication Services sticks out like sore thumb, having done so well this time around. However, before you go about selling your holdings AT&T and Verizon, do note that the largest stocks in the sector are probably not what you have in mind – Facebook, Google, Activision Blizzard, Netflix, Disney etc. In 2018, some of these stocks were reclassified for inclusion into the Communication Services sector, which explains why the performance of the sector for this episode is vastly different from prior instances.

Our takeaway

So in our view, the returns seen for this yield spike episode has been consistent with what we’ve observed historically. In other words, there’s no sector in particular that looks extra interesting to accumulate this time around.

That said, for the reasons mentioned previously, we are positive on the broader market and will be looking to accumulate.

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The InvestQuest View

Rising bond yields are generally positive for stock markets if, 1) the rate of increase is gradual and orderly and, 2) it is rising from a low base. With the recent spike in 10-year UST yields coming in close to the largest short-term yield moves in the past two decades, we are optimistic that rate volatility should subside soon. As such, we are taking a “buy the dip” mentality. We’ll be focusing on some of the mega caps within the tech sector, given that the recent sell-off has been more severe for growth stocks.

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This is Part 1 of our series on rising govt bond yields.

In Part 2, we look at the impact of rising yields on the S-REIT sector in particular (and highlight which S-REITs analysts most bullish about at current prices).