With Rising Yields, Should Investors Sell Stocks and Buy Bonds?
Most investors and readers are aware that interest rates have been on the rise for well over a year now. The yields on savings accounts, CDs, money market funds, and bonds have all gone up. In the risk-free category of U.S. Treasury bonds, the 10-year yield has gone from 1.63% at the beginning of 2022 to over 4% by August 2023.1
It would be reasonable to expect that such attractive yields in the fixed income markets would encourage investors to shift capital away from stocks and towards bonds. After all, the equity risk premium – which is calculated by subtracting the 10-year Treasury bond yield from the S&P 500’s forward earnings yield (E/P) – narrowed to just 70 basis points as of Friday, August 18. By this measure, 70 bps is not a very compelling level of compensation for the added risk of owning stocks versus bonds.
And yet, we have not been witnessing a dramatic rotation from stocks to bonds. In fact, stocks have largely gone up since last October.2
I’ll offer three reasons why.
The first is simply that rising rates mean falling bond prices. With stocks, experienced investors know that it’s often a good idea to buy stocks when they’re falling or when there’s ‘blood on the streets,’ because over time stocks follow the expected path of earnings and economic growth. Recessions and bear markets happen, of course, but throughout history, the economy grows more than it contracts, and corporations’ earnings expand and go up. Stocks don’t stay cheap for long, so it’s been wise historically to buy them when they are.
Bonds are different. When yields go up, the prices of bonds go down. For long duration Treasuries over the past year and a half or so, that’s meant a long stretch of weak/negative performance. It’s not necessarily in investors’ nature to buy more bonds as prices fall. Instead, investors usually think about whether interest rates may continue to go up or not. In the current environment, there’s not a good answer for where interest rates will settle, which I think is a key reason we’re not seeing a major rotation. The Fed’s inflation fight is ongoing, and the economy continues to perform better-than-expected (which justifies higher rates).
As a side note here, Zacks Investment Management actively manages our fixed income portfolio based on our forecasts for interest rates, inflation, and economic growth. We’ve tended to stay on the ‘short’ end of the duration curve for Treasuries because of interest rate risk, while favoring investment-grade corporates for our intermediate and long-duration bond holdings.
The second reason investors have not been dumping stocks to buy bonds is because for many, owning stocks versus bonds is not an either/or decision. In our view, having fixed income in a portfolio is not about making interest rate bets to generate excess returns from bond trading. It’s about establishing an asset allocation that meets an investor’s expectations for long-term, risk-adjusted returns. Unless an investor experiences significant changes to their financial situation, goals, and cash flow needs (which of course does happen), then it’s not likely that their asset allocation should undergo a major change just based on recent performance.
The final reason has to do with the myth that higher interest rates are automatically bad for stocks and the economy. While there’s good logic behind why higher interest rates would crimp growth and profitability, history shows that the U.S. economy and stocks have withstood higher rates on numerous occasions, posting solid growth and performance, respectively, even when rates were much higher than they are today.
In the chart below, the red box highlights the 10-year U.S. Treasury bond yield during the 1990s, which readers can see marks a period when interest rates were higher than they are today. That was also one of the best times for economic growth, and a great time to be invested.
Yield on 10-Year U.S. Treasury Bond
Bottom Line for Investors
I do not want to dismiss the significance of such a narrow equity risk premium, especially when we compare it to what it was just a couple of years ago. In that time, bonds have become more attractive relative to stocks, as yields have gone up, stock multiples have also gone up, and corporate earnings have experienced a weak patch.
But to also suggest that stocks have limited upside potential in the near- to medium-term because interest rates are high and rising does not comport with what we know about stock performance historically. Earnings could very well surprise to the upside, which means stocks could, too. As for bonds, higher yields also imply higher expected returns in the future, which isn’t bad news at all. It just may mean more volatility in the near term.
Disclosure
2 Wall Street Journal. August 16, 2023. https://www.wsj.com/finance/investing/investors-need-to-worry-about-the-bond-markets-return-to-normality-843549b7
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