Bonds this year have been the main source of discomfort for their owners and the key inflictor of the pain the Federal Reserve believes the economy and markets must bear to defeat inflation. The unsettling impact of the relentless ramp in Treasury yields from historic lows to 14-year highs has been as clear and explosive as nitroglycerine: a paralyzed housing market, a Fed-fearing bear market in stocks and inflamed recession fears. Yet the effects from this point of a return to the “old normal” of higher bond yields and positive real (inflation-adjusted) yields, aren’t clearly linear nor entirely negative. On a longer-term basis, the return of more generous safe yield into the financial system should support investors’ ability to shoulder risk, impose discipline on corporate capital allocation, lead to a new equilibrium for equity valuation and restore the benefits of smart diversification. Watching the markets day to day lately leaves the impression that the stock market was a mere puppet of Treasury yields, with higher yields thwarting rallies and pressuring share prices, while each equity uptick seems to require yields to pause or ease back. It’s been true on a tick-by-tick basis, but over time it’s been a looser relationship. The S & P 500 closed Friday at 3752. A month and a day earlier, it finished at 3757. Three months before that, on June 22: 3759 . The 10-year Treasury yield on those dates: 4.24% now, 3.69% Sept. 22 and 3.07% on June 30. This also underscores that the broad stock market, for as challenged and twitchy as it’s been, has not registered any net downside for the past four months even as the market’s projection for the Fed’s terminal short-term rate reached near 5% and leading indicators of a potential recession have been accruing. Comeback for 60/40? The lockstep decline in bond and stock values has laid waste to balanced portfolios and diversification assumptions, of course, producing the worst nine-month stretch for the textbook 60/40 portfolio in many decades. A starting point of rock-bottom yields and above-average equity valuations in an inflationary shock and take-no-prisoners Fed will do that. Yet as stock valuations fall and bond yields rise, risk to a long-term buyer is declining and expected future returns climbs. Which means for as wretched as a 60/40 strategy has been this year, it’s now at a better “entry price.” Keith Lerner, market strategist at Truist Investment Services, ran some numbers on projected returns for 60/40 using present stock and bond conditions, finding that such a portfolio looks set to deliver 6.1% annualized over the next decade; a year ago the estimate was 4.2%, a huge difference in anticipated performance over such a short span. That 6.1% (which of course is a projection and not a guarantee) is made up of 7% S & P 500 total returns and bond-index gains of around 4.5%. Not terribly exciting, perhaps (the trailing 10-year 60/40 annual return was 7.5%), but respectable. Further declines in the near term for stocks and bond prices are of course quite possible but would lift the projected appreciation over a decade. Lerner says, “the main message is now bonds are carrying their weight again and diversified portfolios are in a better place.” Heftier yields on safer assets also means an investor is no longer penalized for risk aversion quite so much. Fifteen months ago, to capture a 6.5% yield meant buying CCC-rated junk debt, the lowest tier of corporate credit with significant default risk built in. Today, that’s essentially the yield on investment-grade corporate bond index. Such a shift occurring across the financial system will surely starve the riskiest companies of credit support, tip a good number into bankruptcy and make growth capital more scarce – not great for economic dynamism in the short term but surely part of the Fed’s program. Stocks vs. bonds But the existence of safe yield doesn’t necessarily mean all money will migrate to safety. An investor getting 4-6% cash income from bonds can buffer a growth-seeking equity portfolio with greater comfort (the first 5% downside in stocks is “covered” so to speak.) Back on the 2010s it became trendy to say low rates led to TINA attitude, one where “There Is No Alternative” to stocks. Never made coherent sense, because yields were low in part because many investors found bonds to be a perfectly fine alternative to equities. And during much of that time, equity inflows were negative – because stock indexes were generally rising which mean the market was lifting investors’ equity exposures for them. In a similar but opposite way, people are talking about how bonds are looking more attractive yet yields keep rising because there’s more selling of bonds than buying – and fixed-income funds just had nine straight weeks of outflows. In fact, if the equity market were falling at the trajectory of long-term bond prices this year, and if the S & P 500 Volatility Index (VIX) were stuck at the stratospheric levels the Treasury market’s ICE BofA MOVE Index is, all the talk would be about whether the climactic capitulation is finally at hand and a good buying opportunity created. Who knows, of course. But Friday’s pause in yields after reports hinted the Fed might consider slowing its tightening pace after one more 0.75-percentatge-point hike on Nov. 2 shows how sensitive bonds would be to the Fed declaring “mission accomplished,” not to mention still-underway economic deceleration that in other circumstances would drive a strong bid in bonds. It’s common to hear market handicappers discuss higher yields compressing overall equity valuations as if it’s a law of physics. Yet the equity risk premium – the difference between the Treasury yield and some measure of shareholders claim on corporate profits – has spent decades either “too high” or “too low.” This depiction of the gap between S & P 500 earnings yield and Treasury yield shows equities look less attractive than they’ve been over most of the time since 2010. But for just about the entire 1980s and ’90s, this gauge was showing stocks unattractively valued as the market was trending strongly higher. It’s a similar story with stocks’ dividend yields relative to bonds. Fewer S & P 500 issues now offer dividend yields above the 10-year Treasury. But pre-2000 the number was even lower. Maybe the difference in these regimes has something to do with the absolute level of bond yields and whether deflation or inflation was the main adversary? Keep in mind, the most extreme overvaluation of large-cap stocks and wildest speculation in no-profit upstarts occurred at a time when Treasuries yielded 5-6% in the late-’90s. Appetites and crowd psychology drive markets in the shorter-term, not math. Unintended consequences The rush from near-yieldless fixed-income assets to decade-and-a-half highs has been so fast that most investors and companies have not had much time to adjust. There will be behavior changes. Hurdle rates for new projects will go up across the economy. Debt, clearly, will become more expensive. Though Citi strategist Scott Chronert ran the numbers on how higher rates will impact 2023 corporate earnings and found higher interest expense will mostly be offset by higher interest earned by companies (largely because the corporate sector locked in mountains of low-cost, long-term debt the past couple of years). Investors, too, have a new risk-reward calculus: Apple has 30-year bonds outstanding that yield 5%, perhaps to some investors an acceptable alternative to Apple shares, which are dependent on the same cash flows but bring more volatility? Stock buybacks will suddenly appear somewhat less attractive from a company’s standpoint when cash can throw off material amounts of income. CFOs might want to lift dividend payouts, especially if they don’t have a persuasive growth story to tell. Less measurably, a higher volume of reliable yield flowing can act to grease the gears of the markets, once bond prices themselves stabilize at whatever level. I’ve noted several times this year that stock and bond values dropping together depletes the aggregate investment community’s ability to add risk and add liquidity. Searing bond volatility instructs every institutional risk-management model to stay under-exposed. Steadier debt values and richer yield flows should steady things and expand investors’ “risk budgets” – so long as this happens before the market machinery blows a gasket or throws a rod. If yields do indeed stay “higher for longer,” as the Fed is promising, there will be unintended consequences, good and ill, that we’ll simply have to wait to learn about.
