Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Investing basics: how rising bonds yields affect your portfolio

Emma Rapaport  |  24 Mar 2021Text size  Decrease  Increase  |  
Email to Friend

A friend came to me last week and said “I put my money in tech stocks, and they've been dropping like a stone. What's going on?”. He's right. The Morningstar Global Technology PR index is down 3 per cent since early February, led by slumps in the price of tech high-flyers such as Apple, Amazon and Netflix. Afterpay (ASX: APT), one of the biggest names on the ASX, has dropped more than 30 per cent since early February highs, while Appen (ASX: APX) is down around 17 per cent. 

At the same time, bond yields are rising. The yield on the 10-year US Treasury bond is about a full percentage point higher now than it was six months ago. And equity sectors and styles which drastically underperformed the index last year like oil and value have begun to show signs of recovery.

What is the relationship between the two markets and why do higher yields put pressure on growth stocks? We reached out to Morningstar senior fund analyst Matthew Wilkinson and Morningstar's director of personal finance Christine Benz to discuss what rising yields mean for your portfolio.

It's important to note that anyone who tells you that they "know" what's going on and how to respond is overselling themselves. The best we can do in this uncertain environment is offer educated theories based on previous market movements.

MORE ON THIS TOPIC: Bond-market rout exposes an assortment of risk

Emma Rapaport: Why are bond prices falling?

Matthew Wilkinson: Over the last year interest rates have dropped to record lows, and that means bond prices are high. There's an inverse relationship between the two. Bond prices have been high because of turbulence in global economies. The global pandemic, shutdowns and boarder closures have wreaked havoc on business communities, forcing governments to pump huge amounts of stimulus into their economies. Central banks have reacted by lowering overnight cash rates to zero or near-zero levels. This affects all durations—not only cash rates but bonds that have a term of 1-yr, 3-yr, 5-yr etc. But we're seeing a shift.

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

Bond yields are rising because they have been at such a low level—it's very difficult for them to fall further. But more importantly, investors believe they're seeing signs of economic recovery. And there's an assumption that a combination of the fiscal stimulus from the Biden administration, quantitative easing, and growth in the economy as the vaccine rolls out could drive up inflation. Investors now believe the risk of inflation is greater than the opposing risk of the economy being weak. This is what's led to the anticipation of higher interest rates. There's an anticipation that the Federal Reserve may act at some point in the future to stave off inflation.

Bond yield: The amount of return a bond earns over time is known as its yield. A bond's yield is its annual interest rate (coupon) divided by its current market price. There is an inverse relationship between a bond's yield and its price. When interest rates rise, bond prices fall (they are sold at a discount from their face value) and their yields rise to be consistent with current market conditions.

Rapaport: Are certain types of bonds (or bond funds) more affected than others?

Christine Benz: When we look at long-term government bonds or long-term corporate bonds even, for the year to date through early March, we see losses of about 10 per cent on indexes and funds that track those indexes that invest in long-term bonds. For short- and intermediate-term bonds, there has been less rate-related volatility. So, those indexes and those products that track them are down about 1 per cent or 2 per cent for the year to date through early March. So, it really depends on what you've invested in.

US Government Stimulus

The US House of Representatives is set to pass a version of President Biden's $1.9 trillion COVID relief bill that includes $1400 stimulus checks for many Americans. Source: AP

Wilkinson: For funds, if you're holding passive allocations to bonds via a managed fund or an ETF; you're going to have a structurally higher allocation to duration. The average bond is going to be around seven years in maturity. If you have an active manager, they can move the average maturity of their portfolio around. The nuance here is the longer your maturity, the more affected you are by the change in interest rate. For example, if you have a maturity of seven years, which is what the global aggerate bond index has, you're more affected by interest rates rises than if you're in a product that has a maturity of less than seven. Most of the major index-aware bond portfolios have a +/- 2 years in terms of duration, but the highly flexible bond managers can go as low as zero (or even negative duration—aka making money when interest rates are falling). Interest rates rising is a headwind to all bond managers, but it's of far greater significance to those with longer-dated bonds.

Duration: The measure of a bond's interest rate risk. It is the weighted average of the time periods until a bond or bond portfolio's interest and principal payments are received, and it's expressed in years. When interest rates change, the price of a bond will change by a corresponding amount related to its duration.

Rapaport: What is the effect on equity markets?

Wilkinson: At a basic level, equity valuations can be determined by assessing cash flows. You discount future years' cash flows by an interest rate. If interest rates rise, the discount increases, therefore valuations decrease. Across the board, valuations of all equities can fall. That doesn't mean prices have to fall. Prices are what is traded between buyer and seller, but valuations from the average analysts indicate that valuations are coming down across the board.

Generally, growth companies, may be producing a lot of revenue but not much if any profit, i.e positive cash flows. The change in their valuation will be much greater than that of an established company with a loyal customer base and reliable revenues/costs. Although those value companies may not have a lot of growth, they will be less affected when rates do rise. Moat and quality in terms of debt levels and margins all go to supporting a valuation. Extreme growth companies are what the market is going to be most focused on selling, and that's what we've seen to date. We've seen a rotation particularly from the high, large cap growth companies that were seen on paper as trading at extreme valuations, PEs of upwards of 50 (the price is 50 times what the earnings are). The market trades on a lot of sentiment. Sentiment can turn quickly and interest rates rising could be that trigger.


US technology companies and other high-growth stocks have succumbed to a selloff in the government bond market. Source: AP

The other side is if a company isn't profitable and has to finance itself. Its debt serviceability becomes higher because interest rates are higher. It must issue bonds. Those bonds used to be issued 1 per cent, now they might be at 2 per cent. That dynamic will drive valuations.

Benz: It's been interesting to see how concentrated that has been with the technology sector, especially really bearing the brunt of those worries. We've seen significant volatility there, and that's a little bit unusual. Because oftentimes, when we do see these inflation and interest-rate worries roil the market, that's oftentimes more concentrated in the economically sensitive sectors, which are often value-leaning. This time, we're seeing it in the growth area. And I think that's simply because that sector, large-growth stocks and mid-growth stocks, were a little bit overvalued coming in to this period. So, they were simply more vulnerable from that standpoint.

Rapaport: If cash rates are at near bottom (0.1 per cent), trailing well below pre-2008 cash rates (+4 per cent), will raising rates by 25 basis points, 50 basis points, even 1 per cent have an impact?

Wilkinson: Valuations are extreme across the board. We may not be at tech-bubble type levels, but we're in that zone. We've got businesses like Tesla and Netflix etc that are high-quality companies in many ways, but they're not producing a lot of profit, they're still trying to grow. In Australia, Afterpay, Zip Co, Xero, WiseTech etc—these businesses are excellent at producing revenue, but they're in a different growth phase—namely early on, not producing steady profits and cash flows. You might not get growth companies trading back down to the average price/earnings ratio, but there's a point where the valuation can't be any higher than it is. Things must change. If rates don't move much further, investors might move back into growth. But if rates grind higher, those discount rates on future cash flows become a major headwind for valuations.

Rapaport: Should investors be making changes to their investment portfolios?

Wilkinson: Investors need to first understand what they're exposed to, and why. If you have a passive allocation to bonds, those exposures have worked very well over the last ten years. Yes, they're now going through a period of headwinds to returns, but that's what happens with all portfolios, and that's what a well-balanced portfolio does. If you think you have a tolerance or intolerance to interest rate rises, you can select other products that are more flexible—e.g. active managers that have more flexibility around sensitivity to rising rates. But we would say a minimum 50 per cent of a bond portfolio is a good place to start to have an index-relative approach to duration. If equities really start to tank, money will move back into fixed interest, long-end bond prices will rise and interest rates will fall. This is the most likely outcome. We've seen this time and time again. That's where your risk-off protection comes from—from long-end duration. If you're only with a flexible manager that has zero duration, you're not going to get that benefit. Your capital might be stable, but you're not going to get upside from price increases. It's about diversifying your risk within the bond market.

When it comes to your equity allocation, it's the same set of questions. What's your current exposure? Are you in value or growth? What kind of managers do you have? Are you happy with the quality? How are they rated? We counsel towards not having too not having extreme allocations to any one particular style or sector. You can exhibit your own personal style whether that be too particular types of companies or industries. But because we've seen growth companies outperform over the last ten years—in an extreme fashion of the past 12 months, investors may have higher exposure to growth-style investments. This is an opportune time to consider rebalancing your portfolio. Taking off the managers that have done well and putting your money to work with those that have lagged.

US value vs growth

Value v growth

Growth manager: A fund that seeks companies that have had fast-growing earnings over the past few years, and, sometimes more importantly, that have the potential to continue to grow for a long time.

Value manager: These managers try to invest in companies at a price that's low relative to their intrinsic value and to the valuation the market has placed on similar companies.

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend