The Fallout From Higher U.S. Yields: A Global Guide for Traders

(Bloomberg) -- It’s no secret that rising U.S. borrowing costs have the potential to roil global financial markets.

But as worries grow that yields on Treasuries -- the world’s lending benchmark -- will once again start to grind higher, analysts across Wall Street are trying to figure out how painful and wide-ranging the knock-on effects might be. While risk assets have regained some of their footing since the selloff in February, market luminaries like Jeffrey Gundlach suggest cracks are likely to re-emerge as 10-year yields push toward 3 percent and beyond.

“There may be no place to hide anymore,” said Scott Peng, chief executive officer at Advocate Capital Management.

Equities and junk bonds are obvious pressure points, and easily could face another bout of selling. Commercial real estate and emerging markets are also vulnerable. There are caveats to every scenario, but here’s a rundown of how things might play out across assets.

Equities

A big force behind the record run-up in equities since the financial crisis has been the fact that stocks have “yielded” far more than fixed income. This is usually expressed in terms of a company’s per-share earnings relative to its stock price, or its earnings yield.

Because equities are riskier than U.S. government debt, many investors like to see an earnings yield that provides a healthy margin of safety. But that cushion is quickly eroding as Treasury yields rise. The S&P 500’s annual profits are equal to 4.48 percent of the index’s price. That’s about the smallest advantage versus 10-year yields -- which are at 2.85 percent -- in eight years.

Of course, not everyone buys into this comparison. But for some, it serves as a handy, back-of-the-envelope gauge of relative value. And you don’t need an apocalyptic scenario (i.e. this one) to see how higher yields could upend stocks. If 10-year yields rose to 3.5 percent, the S&P 500 would have to fall to roughly 2,413 to maintain its current spread. That’s about 13 percent below Tuesday’s close and approaching bear-market levels for the index.

“If rates keep going up and growth isn’t simultaneously increasing, then we start getting pushed into a corner as an equity investor,” said Dubravko Lakos-Bujas, head of U.S equity strategy at JPMorgan Chase & Co.

Rising yields are already causing dividend-paying stocks to fall out of favor. For the first time since 2008, the S&P 500’s dividend yield is below those on two-year notes. Shares of utilities have slumped more than 10 percent in recent months and another abrupt jump in bond yields could compound losses, says Chris Harvey, Wells Fargo & Co.’s head of equity strategy.

Junk Bonds

Low benchmark yields have been a boon for the least creditworthy companies, which have loaded up on cheap debt at historically low rates.

The risk now is that, as the easy money disappears, borrowing costs will jump and ultimately leave a raft of cash-strapped companies that can’t earn enough to cover their debts. For the time being, the extra yield that investors demand to own junk-rated debt instead of Treasuries is still near multi-year lows.

But that spread has started to widen in the past month as junk bonds slump and yields push past 6 percent.

It doesn’t take much to spook junk-bond investors.

As recently as 2016, yields surged above 10 percent as jitters over global growth increased the risk of corporate defaults. This time, the resurgent U.S. economy may keep defaults at bay, even as funding costs rise. Moody’s Investors Service forecasts the global default rate for junk-rated companies will fall to 1.7 percent by year-end, from 2.9 percent in 2017.

Some aren’t waiting around. Speculators are piling into bearish bets against high-yield debt, propelling short interest on the three largest junk-bond ETFs to a record. Meanwhile, the team that runs PGIM’s Total Total Return Bond Fund has been cutting its junk-bond exposure for months.

The asset is one of “the things that would probably underperform in a higher volatility environment,” said Michael Collins, one of the managers of the PGIM fund. “We were chipping away and reducing our exposure.”

Commercial Real Estate

One common factor to all financial assets is a concept called present value. In a nutshell, it uses a risk-free rate (commonly the yield on U.S. government debt) to mathematically determine today’s value of anything expected to generate profits in the future. As rates go up, the current value of those future cash flows goes down, reducing what people are willing to pay for them.

“Every financial asset is a function of its future cash flows,” said Tad Rivelle, chief investment officer for fixed-income at TCW Group, which manages $205 billion. “So there has to be some collision out there between rising yields and valuations” of risk assets.

In a debt-driven business like commercial real estate, higher rates are likely to raise financing costs and reduce property values, which have climbed to records. Last month, the Federal Reserve pointed to commercial real estate as an area where “increasing valuation pressures” are a potential risk.

Some cracks have already emerged. Since September, real estate investment trusts have slumped as much as 19 percent as yields rose. According to an analysis by Wells Fargo, that matched the worst performance during a rising yield environment in 18 years. Commercial mortgage-backed securities are also off to their worst start this decade.

Emerging Markets

Somewhat surprisingly, many analysts are relatively upbeat about the prospects for emerging markets. Borrowers in higher-risk developed countries have historically been held hostage by their dependence on dollar financing. Traditionally, a jump in U.S. borrowing costs would precipitate capital flight as dollar-denominated obligations ballooned in local currency terms.

But now, faster economic growth, more prudent fiscal policies and deeper local debt markets means many emerging economies are more insulated from external shocks. Local currency sovereign bonds are up this year as are developed-nation equities, and Mizuho’s David Costa says Treasury yields need to be closer to 4 percent for any substantial shakeout to occur.

A weaker dollar doesn’t hurt either. Despite the Fed’s interest rate increases in the past year, most emerging-market currencies have rallied against the dollar. That’s helped attract foreign investment. U.S.-based ETFs that invest in emerging markets have garnered $13 billion in net inflows this year, second only to international developed-nation ETFs, data compiled by Bloomberg show.

“EM seems fairly insulated,” said Bradford Jones, who manages the Latin American Opportunities Fund at Sagil Capital.

Even so, the recent outperformance of local-currency government bonds leaves investors with less of a cushion if U.S. yields to start rise in earnest, according to James Lord, a strategist at Morgan Stanley.

“Relative valuations no longer look attractive” after adjusting for inflation expectations, he said.

Volatility

Whatever the case, HSBC strategist Daniel Fenn says a sustained uptick in U.S. yields past 3 percent will cause turbulence across all asset classes to come back in a big way. That may leave investors with few places to take cover.

“When volatility spikes, history tells us it does have a knock-on effect as volatility tends to cluster around all markets,” he said.

--With assistance from Sid Verma and Lu Wang

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net, Michelle F. Davis in Mexico City at mdavis194@bloomberg.net.

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Arie Shapira at ashapira3@bloomberg.net, Michael Tsang, Mark Tannenbaum

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