What rising bond yields mean for equities

Rob Davies, UK equity income strategist at Elston, ​comments in FT Adviser on how higher bond yields affect equities.

"The time value of money means that with higher bond yields, future income (whether coupons from bonds, or dividends from shares) are valued less, in today's terms.  Equity investors can mitigate that impact by investing in "shorter duration equities" that generate near-term dividends, rather than "longer duration equities" that may or may not generate dividends in the distant future. Put simply, when the going gets rough, jam today is worth more than jam tomorrow."

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by Rob Davies, UK Equity Income Strategist at Elston Consulting, and founder and former manager of the VT Munro UK Equity Income fund

Portfolio construction is a tricky business and some may wonder why certain sectors are included. One such sector that investors may question is the equity high income sector. After all, doesn’t everyone just want growth?

Indeed they do but reducing volatility is also an important factor when drawdown is required, whether planned or unplanned. A sharp retracement by markets can have a painful impact on portfolios and taking money out when markets are down can lead to the phenonium of “pound cost ravaging”, selling more stock than planned to get the desired amount of cash. It is the opposite of “pound cost averaging “ during the accumulation stage of investing when you drip money into the market on a continuous basis and accept the volatility to get a reasonable average entry price.

Valuing equities is part art, part science.  The simplest and most common way is the price to earnings ratio. Here earnings, usually expressed as earnings per share, are multiplied by a ratio to derive the share price. Typically, this ratio is higher for companies that are expected to grow rapidly and lower for more pedestrian businesses.

Of course, high income equity funds tend to be overweight more modestly rated companies that offer higher yields. In other words they have a bias to value, i.e. cheaper stocks on modest price to earnings ratios. 

When interest rates rise, that is when bond yields increase, projected earnings of companies are usually revised down.  Money is more expensive and that affects profits. Not all companies are affected equally. Some, like utilities, will be less impacted than high technology growth stocks when expectations are high. So share prices may fall but the value of those earnings will not.

However, the stingy bit is that PE ratios might also fall. That is not normally a major concern for Value stocks because they are not highly rated to start with.  It is though a problem for highly rated stocks where expectations are high, say 30 times earnings. They can suffer the double whammy of lower earnings and a lower ratio of price to those lower earnings . So they get hit twice, first by lower earnings then by lower valuations.  A stock that goes from a PE of 30 to 20 will drop by a third on top of any reductions in earnings. That’s a lot.

An example might help. Take two stocks both expected to earn 10p a share, but one is valued at a PE of 30, because the market expects earnings to grow rapidly, the other at a PE of 10 because it has more modest prospects.  So Growth PLC is valued at 300p and Modest PLC at 100p. Then interest rates rise so earnings at both companies are revised down 10% to 9p. However, the market is disappointed at the lower growth at Growth PLC so it chops the PE ratio by a third to 20. That means it falls to 180p whereas Modest PLC, while still downgraded from a PE of 10 to 9 only falls to 90p. That is a fall of 10% instead of a 40% drop by Growth PLC.    
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Value stocks in a high-income portfolio will not escape bad news entirely, but they will be much less badly hit than the highly valued growth stocks. And for that reason they give stability to a portfolio in times of market stress.

See Rob's comments quoted in FT Adviser