Bond selloff prompts stock investors to confront rising rates

The lift in yields largely reflects investor expectations of a strong economic recovery. However, the collateral damage could include higher borrowing costs for businesses, more options for investors who had seen few alternatives to stocks and less favorable valuation models for some hot technology shares, investors and analysts said.

As of Friday, the yield on the benchmark 10-year U.S. Treasury note stood at 1.344%, up from 1.157% just five trading sessions earlier and roughly 0.9% at the start of the year.

The S&P 500 fell 0.7% for the week, dragged down largely by technology stocks, which after big gains in recent years are seen as especially vulnerable to rising yields. Banks, meanwhile, rose as investors bet that higher long-term interest rates would make their lending activity more profitable.

“The market’s wobbled a little bit," said Brad McMillan, chief investment officer at Commonwealth Financial Network, an investment advisory and brokerage firm. “The market has principally been saying hooray, the pandemic is coming under control and the economy is starting to grow again. But now we’re actually starting to see the consequences of that in the form of higher rates, and I think the market’s processing that."

Stuck near historic lows for most of last year, Treasury yields have climbed in recent months along with investors’ expectations for a strong economic rebound, driven in part by more debt-financed government spending.

The move over the past week caught investors’ attention because no specific catalyst was apparent. That raised the prospect that yields could rise more quickly and unpredictably than expected—an outcome that many believe would be more disruptive to other assets like stocks than a slow, orderly climb.

Rising yields, which result from falling bond prices, often reflect investor expectations of faster growth and an accompanying rise in inflation, which makes the interest payments of bonds less valuable. A pickup in inflation could also eventually lead the Federal Reserve to raise short-term interest rates, though most investors don’t expect that to happen in the near term. More government borrowing could boost yields as well just by increasing the supply of bonds.

Investors this week will monitor the latest developments in Washington, where House Democrats hope to finalize a $1.9 trillion stimulus package, as well as figures on consumer spending and earnings from consumer companies like Home Depot Inc. and Macy’s Inc.

They will also keep watching Treasury yields, whose rise can hurt stocks in a few different ways, according to investors and analysts.

As yields move up, borrowing costs for most businesses should also rise, crimping profits. Higher yields could also prompt some risk-averse investors to sell stocks and return to government and corporate bonds, now that they will earn a more meaningful return.

Finally, many investors use the 10-year Treasury yield as a discount rate in formulas to value stocks. All else being equal, the expected cash flows of companies are considered less valuable when yields are higher. That could threaten many tech stocks because much of their earnings are expected to come further in the future.

Treasury yields remain extremely low by historical standards but aren’t so low relative to stock prices, some argue. In recent years, the 12-month forward-earnings yield of world technology companies—their expected earnings per share as a percentage of their stock price—has generally exceeded the 10-year Treasury yield by at least 2.5 percentage points.

But the yield differential has recently fallen below that threshold, a sign that the stock-market rally that was previously justified by ultralow bond yields “is turning irrational," Dhaval Joshi, chief European investment strategist at BCA Research, a Montreal-based investment research firm, wrote in a report last week.

Still, many investors aren’t too worried about rising yields, seeing them mostly as a welcome sign that the economic outlook is improving.

“Our base case is for the positives of a higher rate regime to outweigh the negatives," said Matt Peron, director of research at Janus Henderson Investors.

Many professional stock investors have already baked higher yields into their valuation models, and the largest tech companies generally have earnings that justify their prices, he added.

Even so, rising yields could cause investors to rethink their allocations to different sectors, Mr. Peron said.

His own team started adding exposure in the second half of last year to companies such as certain retail brands and online travel businesses that stand to benefit from an economic recovery and are less vulnerable to rising rates.

The impact on stocks depends a lot on how high and how quickly yields can rise, analysts said. A range of analysts forecast that the 10-year Treasury yield will reach anywhere from 1.5% to 2% by the end of the year, as investors start preparing for future rate increases from the Fed.

So far, the sudden rise in yields reflects uncertainty about the future more than any tangible changes in the economy. Earlier this month, the Labor Department reported that core consumer prices, excluding the often volatile food and energy categories, were essentially flat for the previous two months.

Treasury yields fell at the time, only to begin their latest steep ascent just two days later.

This story has been published from a wire agency feed without modifications to the text.