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OPINION

Bond market risks for shares

Bond market risks for shares
January 7, 2022
Bond market risks for shares

We start 2022 as we started so many previous years, with investors worrying about the possibility of rising bond yields. What equity investors have to fear more, however, is perhaps the opposite risk – that yields actually fall.

To see this, let’s consider some mechanisms whereby rising yields might hurt equities.

One is that the higher bond yields are the more expensive shares will seem relative to them, and so the less keen will be investors to hold equities.

Undoubtedly, this was a reason in the past for shares to suffer from rising yields. In the 80s and 90s the gap between equity and bond yields was reasonably stable, so rises in the latter triggered rises in equity yields and hence falls in share prices. But today the danger is greatly mitigated by the fact that UK equities are remarkably cheap by historic standards. The dividend yield on the All-share index is now 5.6 percentage points above the 20-year index-linked gilt yield. This is near a record high. Even if bond yields were to rise by a full percentage point, equities would still be cheaper relative to bonds than they were at any time in the 20 years before 2014.

The problem for equities is not that rising bond yields will make them seem expensive. It is that they might now be cheap for a very good reason – that they offer little long-term growth.

 A second threat is simply that a sell-off in bonds will make investors poorer; a one percentage point rise in ten-year gilt yields will take 8.5 per cent off their price. And poorer people buy fewer equities.

This mechanism is offset by another. Higher bond yields mean that final salary pension schemes will apply a higher discount rate to their future liabilities – the income they must pay future pensioners. This would reduce the net present value of those liabilities thereby strengthening their balance sheet and enabling them to buy more equities.

Perhaps a greater danger from rising yields lies in the US market, and has been pointed out by Princeton University’s Atif Mian and colleagues. They show that low and falling bond yields have “disproportionately benefited” superstar companies because the cost of borrowing falls more for them than for other companies, enabling them to expand faster than others.

Rising yields could reverse this process. And because such firms account for so much of the S&P 500, the entire US market would be dragged down; the biggest five stocks (Apple (US:AAPL), Amazon (US:AMZN) Tesla (US:TSLA), Alphabet (US:GOOG) and Microsoft (US:MSFT)) account for over 23 per cent of the S&P 500.

We got a hint of this on 5 January when the Fed’s hint that it will raise interest rates – a move that should have been widely expected – triggered a big drop in the S&P.

You might think this is less of a problem for the UK market, which doesn’t have such superstar firms. True. But it is not immune. Falls in the prices of huge US stocks would cut investors’ wealth and therefore their demand for shares generally, including UK ones. Most stocks around the world are correlated with each other to some extent, so a drop in the US market would reduce UK prices somewhat.

But a bigger issue than any of these is: why would bond yields rise?

The likeliest reason would be that inflation proves to be higher than expected, causing investors to revise up their expectations for short-term interest rates, with knock-on effects onto yields.

Such a scenario is not necessarily bad for equities, however. A world in which demand is strong enough to cause sustained inflation and in which central bankers are confident enough about the economy to raise interest rates is one in which corporate earnings are growing and appetite for risk increasing, That’s good for equities.

This, however, is only one possible scenario. If higher inflation is due to increased prices of gas (and perhaps, though less likely, other commodities) it would squeeze incomes and profits – a squeeze which would be made worse by rising short-term rates.

While this would hurt equities it would not be so disastrous for bonds. The same econimic growth fears that would depress share prices would also hold down bond yields. And this is not to mention another possibility – that economic growth might be disappointing for other reasons such as weak growth in China or UK fiscal policy squeezing demand.

And herein lies the point. The bigger danger for equities is not so much rising yields but falling ones – because a world in which yields are falling is one in which investors are nervous.

Yes, rising yields would change the investment climate, perhaps by triggering a shift from growth to value investing, and might unsettle equities occasionally simply because the scenario is so unfamiliar. But the alternative would be worse.