Investors in long-dated US and European government bonds have lost 15-20% over the past four to five months. Bond yields have risen from record lows, meaning prices have fallen. So far, stock markets have been unaffected. But for how long? Eventually, rising bond yields could mean falling stocks. Is Mr. Bond about to sink the stock market?
Ultimately all investing comes down to the cost of money. Since investors have a range of investment choices, there’s an interplay between different asset markets.
What stock investors will pay for their investments depends to a large extent on what else is on offer, and the main alternative is bonds. And so, to understand the risk of rising bond yields for stock markets, we first need a good grounding in how bonds work.
Would you prefer if I pay you $100 today or $105 in one year’s time? The answer to that is “it depends”.
Let’s say a bank deposit will pay 5% interest. A hundred dollars could be placed in the bank and grow to $105 in a year’s time. In which case there is no difference between getting $100 today, and putting it on deposit, or a reliable promise to get $105 in one year’s time (assuming you don’t need the money for a year).
Money, just like everything else, has a price. If someone else wants to use my money for a time – meaning I can’t use it while they have it – I charge them something for the privilege. This is the essence of investing. Money is parked somewhere in return for the hope of a profit.
This concept is known as “the time value of money”. Put more colloquially, you can think of it as “a bird in the hand is worth two in the bush”.
You can have the certainty of something today (your savings) or the uncertainty of getting that amount plus more money in future (your investments). The more risky the investments are judged to be, the bigger the potential profit needed to persuade investors to give up their money for a time. The expected, if uncertain, return must be big enough to make up for the risk.
Let’s think about that in the context of bonds. Say bond investors want a 5% return over one year, and a one year bond bought today will pay back $100 in one year’s time plus $5 of interest (the “coupon”).
In other words the investor will receive $105 in total, but not until a year from today. Since the investor wants a 5% return they’ll be prepared to pay $100 today to buy the bond.
But what if bond investors suddenly decide that a 4% return is acceptable, perhaps because price inflation falls from 3% to 2%? That way they’d still make a return that’s 2% above inflation (their “real” return).
A “fixed income” bond does as the name suggests – it pays a fixed amount of income. So the same bond as before will still pay $5 interest. But investors only need 4% now to get their desired return, which means they’ll pay a higher price for the bond. It would rise from $100 to $100.96.
How so? Well the cost to buy the bond, its price, is now $100.96. The money received in future will be the exact same $105 received in a year’s time.
So the net profit – money out less money in – is now $4.04. That’s 4% of the new price of $100.96, which is the new required return.
From this you can see why bond prices rise when yields fall. The fixed future cash payments to the investors stay the same. But as the price of money comes down (the yield) investors will pay more to receive those fixed future payments.
That was a really simple example of a one year bond. It has one single interest payment as well as the repayment of the principal amount borrowed. A 30 year bond will usually have 60 semi-annual interest payments (coupons), and a final repayment of principal when it matures in 30 years.
But the idea is the same. Bond investors want a certain return on their money, and they value each future cash receipt according to that. Then they add up all the individual pieces to come to a total price that they’ll pay today. In return they get that package of future income payments.
What’s been happening recently is that the price of money has been increasing. Yields demanded by bond investors have been rising (from all time record lows) – and hence bond prices have been falling.
You may be wondering what this has all got to do with stocks. In my last article I wrote: “Equity investors expect a higher return than bonds offer, to make up for the extra risk involved. As bond yields rise, so does how much investors in stocks want to make in future. To achieve that, market multiples like the P/E have to fall.”
A reader didn’t agree with this statement. He happens to be a market professional and someone I’ve met several times in London. I’ll call him “John”. He wrote this:
“It isn’t true to say that stock investors require extra returns to compensate for the extra risk. It was observed that stocks did consistently well against bonds and the theory arose that the explanation must be that stock investors required a higher return. There is a subtle but vital distinction. If the theory was being formulated today, on the back of the last generation of data, there would be no distinction and so no need for the theory of risk and required return. Therefore, now that stocks are, by this definition, no longer riskier than bonds, how should you invest?”
Let’s dig into what John is saying here, and why I think he’s wrong. For that we need to delve into a little market history, and I’ll use the US to make the points.
Since 1900 the US stock market has returned 9.4% a year. By comparison, 10 year US government bonds have returned 5% a year.
Inflation averaged 3% a year, meaning the “real” (above inflation) returns were 6.4% for stocks and 2% for bonds. These figures are based on data from the Credit Suisse Global Investment Returns Yearbook 2016.
This means stocks have returned, on average, 4.4% a year more than bonds. The extra return is known as the “equity risk premium”, and is assumed to make up for the extra risk of owning stocks instead of government bonds.
But John makes an interesting observation. Things haven’t been that way for the past 35 years, since 1980. Bonds have been in a massive bull run since then, and their returns have nearly matched stocks. In fact, for much of the time they’ve beaten stocks.
From 1980 to 2012 bonds had a real (above inflation) return of 6.3%, versus the real return on stocks of 7.5%. This means the average performance gap was just 1.2% a year.
Between 2000 and 2015 bonds made 5.4% real return, beating the 2.3% from US stocks. That means the “premium” for owning stocks turned into a 3.1% discount. But of course 2000 was a bubble year for stocks. It was the end of the tech bubble, when market valuation multiples reached record highs.
Unfortunately I don’t have data for the period from 1980 to today. But you can see the point. Bonds have performed extremely well since 1980, and practically matched stocks.
So is the whole idea that stock investors should get a much higher return than bond investors nonsense? Was the idea of the “equity risk premium” just a theory that was made to fit the historical facts? And have the facts now changed to the extent that we should throw out the theory?
There are several important reasons why I don’t think so, and why rising bond yields could be negative for stocks (eventually). Next time I’ll explain how Mr. Bond could one day sink the stock market.
Stay tuned OfWealthers,