Why Rising Bond Yields are a Threat to Equity Investors

Think rising interest rates only impact fixed income investors? Think again, it is stock market investors who may feel the biggest impact

Emma Wall 5 November, 2018 | 8:23AM
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Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Janus Henderson's Jay Sivapalan to talk about interest rates.

Hi, Jay.

Jay Sivapalan: Hi, Emma. Thanks for having me.

Wall: Well, we're in an environment now where interest rates are rather diverging. We've got the US raising rates at quite a steady level. Here in Australia, rates are still low and the same is the case in Europe and in the UK For investors globally, individual investors globally, how important is it or how mindful should they be that the US is raising interest rates?

Sivapalan: Yeah. I think, Emma, when we look at interest rates and think through the last decade and how we've got here, it's very important to understand that we've spent a full decade essentially in ultra-easy monetary policy which has had different impacts for different economies. Clearly, the US is very advanced in terms of its recovery and now very strong economic growth and there are other parts of the world such as Europe, Japan and to some extent in Australia where we are lagging behind significantly.

So, rising rates is a phenomenon that we are going to experience over the years ahead. Certainly, the Fed is on a mission to keep raising rates and other central banks like the RBA probably won't touch interest rates this year or next year and perhaps not even in 2020.

What has happened from a return perspective for investors and the implications is that the ultra-easy monetary policy has allowed a lot of assets to be elevated in terms of pricing and that has implications going forward. So, investors should think about how they are constructing their portfolios in what we would consider the second half of an economic cycle.

Wall: And for those investors looking forward what happens in the second half of that economic cycle?

Sivapalan: So, I think, that second half of the economic cycle from an investment perspective, from a portfolio construction perspective, it's no longer as easy to rely on good economic growth coupled with good asset price inflation or growth. So, it is going to be a higher inflationary environment, albeit – I will temper that to say that that's largely an US phenomenon. So, it means that investors have to think about defensive assets, they have to think about where can we get income without necessarily the capital volatility. So, certainly, absolute return-type of investing and thinking is much more important today than it was three years ago.

Wall: And you are a fixed income investor, but I think you made a really interesting point about the impact that rising bond yields have not just on investors who have fixed interest in their portfolio, but actually on equity investors as well. We are speaking here at the Morningstar Individual Conference and you said, actually, it's probably even equities that have the bigger impact sometimes from rising bond rates?

Sivapalan: That's right. So, typically rising cash rates and rising bond yields at the early part of an economic cycle, as we've been in for the last, say, three to five years in the US is not necessarily bad as long as it's coupled with good earnings growth and we've certainly seen that come through in equity markets, infrastructure assets have held up pretty well, property assets. But these are all real asset classes that have been elevated in value whilst the discount rate or risk-free rates have been very low. From here on there can be a greater impact by rising rates and rising bond yields on the valuations of those. And as long as you've got earnings following through, that's fine. But if earnings are not following through at the same rate, it can be a bit more of a challenging environment for investors.

Wall: Because simply, why take the extra risk that's associated with equities when bonds are increasingly paying you an attractive level of income?

Sivapalan: You're speaking my language here. Now, all jokes aside, what we would say is that especially when you look at markets like the US where the risk-free rate has risen. And it was an interesting comment that someone made on Bloomberg recently that US is one of the higher-yielding markets in the world. You can, and investors can buy very good quality corporate debt, say, for five-year terms or 10-year terms at a yield of around 4%. So, when you think about the investment opportunities for investors, a rising rate environment in due course is actually very good for investors where investors can buy defensive assets at reasonable yields without the capital fluctuation or putting their money at risk. Now, of course, that rising interest rate needs to be managed and active interest rate management is a key part of that.

Wall: Jay, thank you very much.

Sivapalan: Okay. Thanks, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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