13 July 2018
Some of our clients have been asking us if we’re in a bond bubble, and what that means for equities.
We are seeing a flattening yield curve and rising interest rates. The bull cycle for bonds has officially ended but the bear cycle is likely to be mild.
Bond yields are likely to rise gradually because solid economic growth has not been accompanied by big surges in wages or inflation. This means that the US Federal Reserve is likely to hike interest rates gradually.
The second reason why rises in bond yields are likely to be gradual is related to the flattening yield curve. In past bear market analyses, the data have shown that when the yield curve flattened to the point of being inverted (i.e. long-term yield lower than short-term), there is a risk of a subsequent recession. Historically speaking, an inverted yield curve tends to precede a recession by 18 months. From the angle of the flattening yield curve, the Fed is likely to be very careful to avoid hiking rates too much and too fast, as this would risk inverting the yield curve. While the Fed downplays this in public, it is certainly on their radar, in our view.
Recall that the total return for bonds can be broken down into (A) price returns and (B) income. A rise in bond yields due to rate hikes creates negative price returns but also means higher income. The key point here is the gradual rate hikes, as the price returns become negative more slowly, but bondholders have more time to accrue higher income.
There is a tussle between the two components of a bond returns: income vs price. In the table below, the US Fed hiked interest rate three times in 2017, but the total returns for bond ETFs were not negative. SHY delivered 0.6%, VGIT gained 2%, TLH gained 4.4% and TLT gained 9%, respectively. These returns are because of the gradual rate hikes. More importantly, a gradual rate rise environment means that bonds can still function as risk reducers to a growth-oriented portfolio. In 2018 thus far, we are first seeing the immediate effects of rate hikes, but higher income associated with higher yields would kick in later on if rate hikes remain gradual. The chart below is as of 12 July 2018.
So how do these rate hikes affect equities? When equity markets are bubbly, a rise in bond yields reduces equity returns. Recall the DCF (discounted cash-flow model for valuing cashflows of a stock): when bond yields are rising but not accompanied by higher earnings due to a bubbly market, the present value of future earnings would decline.
When equity markets are closer to “fair”, a rise in bond yields may not be negative for equity returns. Generally, when bond yields are rising in reflection of better economic fundamentals, future earnings of a stock are also rising. So although higher yields mean lower present value, the continued improvement in the earnings of stocks tend to be larger than the negative impact of a rise in bond yields. In our opinion, we are more likely experiencing this case given that we experienced the stock market correction earlier this year.