Yield Investing is Losing its Luster
In a reversal of its multi-year decline, the yield for the 10-year Treasury bond has been rising significantly and recently broke out above its trendline. We believe this signals a major inflection in the bond market and the potential continuation of the underperformance of “bond-like equites.”
In 2016, we forecasted that rising interest rates and inflation concerns would eventually cause investors to sell bonds in favor of equities, or a process that we have called “The Great Rotation.” Since the second half of 2016, equity strategies targeting yields as well as the bond market have been weak, especially in comparison to the strong returns of growth equities. Through 2017 and continuing into 2018, expectations for economic growth and anticipation of inflation signal that interest rates likely will continue climbing. The decade-plus long bull market in bonds appears to have ended. 

However, judging by investment flows, it does not appear that the average investor fully appreciates the impact of rising rates on their bond portfolios. We’re not surprised since after more than a decade of declining interest rates supporting the bond bull market it would be natural for many investors to be complacent. The impact of rising interest rates on bond returns is significant. A 100 basis point (bp) increase in the yield of a typical 10-year bond would reduce its value by 8%. The loss in value in a bond is fixed to the overall interest rate environment, unlike a stock investment where the quality and direction of a company’s fundamental growth determines its value. Further, many bond investors have shifted to shorter duration bonds to minimize the negative effects of rising interest rates. However, inflation is already at levels, and has the potential to rise further in coming years, such that these investors in short term bonds will likely have zero or negative real returns after inflation. 

We believe that attractive equity valuations are also likely to support the Great Rotation, with the S&P 500 Index offering an earnings yield that is more than 300 bps higher than the yield of a 10-year Treasury (as of February 28, 2018). During the 50 years leading up to the Great Recession, the earnings yield of the index averaged only 55 bps more than the 10-year Treasury.

We believe the Great Rotation will involve not only an increase in flows to equities, but also a focus on corporate fundamentals, including earnings growth, rather than dividend yield. This shift with equities has already started, as illustrated by the Information Technology, Consumer Discretionary, and Health Care sectors being among the top performing sectors within the S&P 500 year to date as of late March. Sectors such as Energy, Consumer Staples, Telecommunication Services, and Real Estate, all of which are characterized as having companies with high dividend yields, meanwhile, substantially underperformed the overall market. 

Continuing to seek yield with bonds and with bond-like equities may carry the risk of capital loss due to a potential increase in interest rates. To that end, we expect investors will turn their attention to equity markets and stocks of companies with strong earnings growth as a viable alternative to fixed income and stocks with high dividend yields.​