Rise of bond yields is a double edged sword

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Mark Burgess, CIO EMEA and global head of Equities at Columbia Threadneedle Investments comments on challenges in fixed income and prospects in UK and European equities. 

There is an old adage in stock markets which suggests that investors should ‘sell in May, go away, and don’t come back until St Leger’s Day’. While we would never advocate such a simplistic strategy in an era of interdependent and interconnected financial markets, some investors will undoubtedly wish that they had sold and gone away given the weakness that is now being seen in bond markets.

Since the beginning of April, the yield on the benchmark 10-year US Treasury has climbed from 1.86% to 2.25% at the time of writing. While credit markets have ridden out the storm so far, longer-duration assets such as investment-grade credit are bound to come under some pressure if core bond yields continue to rise at the rate seen recently. The point at which core bond yields become attractive again is still some way off in our view. Nonetheless, the weakness in bond markets will certainly provide income-seeking and ‘go anywhere’ investors with plenty of food for thought.

For equities, the rise in bond yields is something of a double-edged sword. On the one hand, rising yields imply a stronger economic growth outlook and a return to normality following a period of very low or even negative bond yields. On the other hand, a prolonged and sustained rise in bond yields means that risk-free discount rates are likely to rise, which is unhelpful for equities, as the value of future earnings and profits is calculated by using a risk-free rate. Given that equity market returns in recent years have been driven by a valuation re-rating and the abundant liquidity provided by QE, rather than by earnings growth, a bond market sell-off could prove to be unsettling for stocks.

As we have discussed in our recent updates, we remain overweight equities in our asset allocation portfolios but have been taking a little money out of equities as a risk-reduction measure.

  • Within equities, we continue to overweight Japan, the UK, Europe excluding the UK and Asia excluding Japan, while we remain underweight US and emerging market equities.
  • In fixed income, we believe that the additional yield pick up from investment grade over government bonds – around 130bps for high-quality US investment grade – will provide support for the asset class given the lack of obvious alternatives, particularly for investors who can only invest in fixed income. Nonetheless, higher government yields suggest choppier waters for credit markets in the short term. We will be monitoring developments closely and we are running a short duration stance in our retail credit portfolios.

Our overweight in UK equities has worked well in recent days as the FTSE has rallied to within touching distance of its all-time high following a surprise general election result that saw the Conservative Party secure an outright, albeit small, majority. Scotland, meanwhile, is now in effect a one-party state with the SNP controlling 56 of the 59 Scottish seats at Westminster. In the coming weeks and months, the noise around further devolution and federalism is likely to increase, and further out on the horizon is a promised referendum on EU membership in 2017. In the short term, markets have clearly liked the election result and sterling has also rallied, but the longer-term outlook for the UK’s role in Europe is perhaps more uncertain now than at any time since the mid-1970s.

Mona Dohle
Mona Dohle speaks German and Dutch, she is DACH & Benelux Correspondent for InvestmentEurope. Prior to that, she worked as a journalist in Egypt and Palestine. She started her career as a journalist working for a local German newspaper. Mona graduated with an MSc in Development Studies from SOAS and has completed the CISI Certificate in International Wealth and Investment Management.

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