Equity investors are being reminded that interest rates are a double-edged sword. After a three-decade period when falling interest rates and bond yields provided a boost to stock prices, the potential for a sustained rise in yields has equities deep in the red in recent days.
It is an iron law of finance math (discounted cash flow, specifically) that future cash streams like corporate earnings and dividends are worth steadily more as interest rates fall. Stock prices, as representing an estimate of the current value of future profits, should automatically rise as rates decline. More basically, lower bond yields make bonds less attractive relative to equities.
A close look at the last 20 years of performance history uncovers the domestic utility and real estate sectors as the most sensitive to interest rate changes, and thus they are the most at risk from rising interest rates and bond yields. Both industries are capital-intensive, requiring frequent loan rollovers and bond issues, so higher borrowing costs have outsized effects on bottom line profits.
The first chart below compares the five-year government of Canada bond yield with the S&P/TSX utilities index. The inverse correlation – utilities' stock prices moving in the opposite direction of yields – is immediately apparent in January of 2000 when the 20-year high in yields corresponded almost exactly with the low in utility stock values.
The relationship got muddled in the lead up to the financial crisis but had reasserted itself by mid-2010 as utility stock prices rallied while bond yields steadily fell.
The patterns are almost identical in the second chart that shows the S&P/TSX real estate index and the five-year bond yield. Outside of the financial crisis, they have moved in opposing directions.
It is important to note that while bond yields are rising, they are only back at 2011 levels when performance in both utilities and real estate stocks was still strong. Current conditions are unlikely to cause severe stress in either case. The negative effects of higher interest costs can also be offset where companies have the ability to raise prices or rents if economic conditions improve.
It is also the case that we've had numerous false alarms where economists have predicted a bottom in interest rates and a new long-term trend of higher bond yields and inflation pressures. To date, none of them have proven accurate.
Investors in utility and real estate stocks – and indeed all dividend-paying equity sectors – should, however, recognize the threat that further increases in bond yields would present to future portfolio returns.