Interest Rates and Equities

Over the past few months, long term bond yields have risen by 1% or more in all significant developed economies, apart from Japan. In many economies, long term bond yields are now more than 2% higher than their 2020 lows. The graph below shows how US and NZ 10-year bond yields have risen over the past 2 years.

 This rise in bond yields clearly has implications for equity markets, because investors can allocate between bonds and equities, and may therefore reduce their allocation to equities if bonds become more attractive.  Investors should logically compare the long run return they expect to get from investing in equities to the yield available on long term government bonds, and switch from equities into bonds if the expected return from equities does not exceed the yield on government bonds by a sufficient margin to compensate for the greater risk associated with equities.

However, it would be alarmist to assume that a 2% rise in global bond yields means that the gap between likely equity returns and likely bond returns (a.k.a. the “equity risk premium”) has narrowed by 2%. A significant element of the rise in bond yields is clearly a response to a rise in inflation expectations, and (in theory at least) higher inflation should boost long terms expected returns from the share market, as inflation will ultimately add to the notional revenues and profits of listed companies.

But it is important to note that while there are theoretical reasons for expecting equities to provide a good hedge against inflation, the empirical evidence is not so clear-cut. In particular, global equities produced particularly poor returns from the late 1960s through to the early 1980s, which also happened to be the most inflationary period of the last hundred years.   

The long run return from investing in an equity market will be (roughly) equal to the long-term growth of that equity market plus the net cash yield that listed companies return to shareholders. To calculate this net cash yield, you need to consider not only dividends, but also take account of the cash that has been effectively returned to shareholders through share buybacks, as well as the cash that listed companies have indirectly taken back from shareholders through share issuance.

In aggregate, the US share market pays a dividend yield of about 1.5%. While the longer-term trend has been for the value of share buybacks to slightly exceed the value of share issuance (meaning that US share market indices have historically outpaced the growth in the capitalisation of the share market), the opposite has been true over past year. Over the past year, if a passive investor in the US share market wanted to maintain a constant percentage ownership on the US share market, they could have only taken out a cash yield of 0.2% from their portfolio, as most of the dividend income they received would have been used up buying a proportionate slice of all the additional equity that listed companies had issued over the course of the year.  

But if we write this past year off as anomaly, we might assume that in the long term, returns to investors in the US share market will exceed the growth in its capitalisation by something like 1.7% (due to the cash that shareholders receive from dividends and buybacks). If we assume that the value of the US share market will grow in line with US GDP, which has averaged about 5% annual growth over the past 40 years, then we could project a buy-and-hold return from investing in US equities of about 6.7% per annum. On the face of it, it still seems reasonable for investors to anticipate a reasonable equity risk premium of 4% per annum (assuming they’re not investing in the market through a fund that charges excessive fees!), which may be regarded as a reasonable premium for the risks involved. However, equity valuations will be vulnerable if bond yields continue to move higher.

Which Equities are most vulnerable to rising bond yields?

The relative outperformance of growth stocks between 2018 and 2021 was fuelled in large part by lower bond yields. Most of this outperformance has already reversed in the first few months of 2022, as bond yields have returned to where they were in 2018. This is not just a coincidence.

The valuation of growth companies is particularly sensitive to interest rates, because (by definition) a relatively greater proportion of the value of a growth company relates to the cashflow that the growth company is expected to be able to deliver to shareholders several decades into the future, and the present day value that you can reasonably attribute to cashflows that are several decades into the future will depend heavily on what sort of return you need from your money over the intervening decades.       

To illustrate this point, consider two companies at almost opposite ends of the perceived growth spectrum: Verizon and Tesla. Verizon is the largest US telco, and is generating significant cashflow, but broker analysts do not generally anticipate strong growth in the amount of cash that it returns to shareholders over the next few decades. By contrast, Tesla has just recently begun to generate more cash than it spends, and it is not yet returning any cash to shareholders, but analysts are optimistic that Tesla’s ability to generate free cashflow will grow exponentially over the next decade. Although Verizon is currently the more profitable of the two businesses, the share market implicitly says that Tesla’s equity is 4.65 times as valuable as Verizon’s.

If we use near term expectations for each company as a starting point, we can draw a reasonable inference about what sort of cashflow these two companies would need to return to shareholders in order to deliver a buy and hold return of 8% per annum to shareholders. Based on our analysis, the graph below presents the implicit future cashflows for each business that would be consistent with an 8% buy-and-hold return.

 

 

This analysis suggests that well over half of the value of Verizon relates to the cashflows that it will return to shareholders over the next 15 years, and that the market implicitly expects very little growth in Verizon’s cash generation beyond that 15-year time horizon.

On the other hand, only about 2% of the value of Tesla seems to relate to the cash that it is expected to return to shareholders over the next 15 years, and the bulk of its value is related to cashflow that it is expected to generate more than 35 years into the future. The price that shareholders pay today for cashflows that are so far into the future should be very sensitive to the rate of return than Tesla shareholders demand from their investment.

To see how sensitive the value of each stock might be to a further rise in interest rates, we can calculate how the present-day value of each company should change if instead of demanding an 8% return, shareholders decided that they now needed a 9% return to justify continued investment in each company. By our analysis, this 1% increase in the required return would reduce the value of Verizon’s stock by 14.3%, but would reduce the value of Tesla’s stock by 32.5%.

Theory vs reality

In practice, share markets are not as sensitive to interest rates as this sort of analysis would suggest. We believe there are two principal reasons for this:

1. Bonds and equities are not perfect substitutes. Many investors only hold one of these two asset classes, and many investors who do hold both bonds and equities will not significantly change their asset allocation in response to a change in bond yields. While the implicit discount rates that equity investors use to value equities do change in response to changes in interest rates, the relationship is much weaker than one-for-one.
2. Changes in bond yields are partly driven by long term inflation expectations, and changes in long term inflation expectations also affect expectations for the long-term rate of growth in the cash-generating ability of listed companies.

The possibility of further rises in bond yields presents a significant risk to the valuation of global equity markets. The value of growth companies could be particularly sensitive to further increases in bond yields.

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that hold shares in Verizon.