When will bonds be attractive again?

With a short term inflation spike about to land on markets BofA takes a look at the critical bond yield levels that would upset stocks:

No more TINA

The long-standing bullish mantra for stocks has been “There is no alternative” or TINA. Especially for income investors, given that the S&P 500 dividend yield has been within spitting (100bp) distance of bond yields for 104 of the last 120 months. Today over 60% of S&P 500 stocks pay a dividend yield that is above the 10-yr yield. But our rates strategists’ forecast for a 10-yr yield of 1.75% by year-end renders TINA less compelling. The opportunities for higher dividend yielders would drop well below 50% (Exhibit 1) and the S&P 500 yield would fail to clear bond yields. But rising rates alone aren’t bad for stocks: stocks posted positive returns 13 of the last 15 rising rate cycles.

What’s the magic number?

What’s the level of 10-year yields at which income-oriented investors (which today comprise close to 40% of actively managed money) go back to bonds?Different frameworks yield different answers with one particularly close to where rates are today:

1.5% is the 10-yr yield above which, following the GFC, the average recommended stock allocation was~50%, well below the current recommended allocation of 58.4%.

3% is the implied price return p.a. of the S&P 500 through 2031 based on its current price to normalized earnings ratio (a model that has explained over 80% of long-term S&P 500 returns). An equivalent but risk-free yield on bonds would compare favorably.

4% is the level at which the spread between the S&P 500’scurrent dividend yield and 10-yr yield drives decreasing allocations to stocks for investors.

5%is the level at which stocks trade at fair value to bonds, all else equal. 5%is also when the reward-to-risk ratio for stocks vs. bonds skews favorably toward bonds.

What to own (and avoid) on the move higher

Both ends of the equity duration spectrum are at risk: long duration growth stocks that benefited from a falling discount rate could suffer a reversal of fortune. And short duration high-coupon stocks with no room to raise dividends would pale relative to bond income. Where will income investors go? Dividend growth stocks with inflation-and rising-rate protected yield(often found in Quintile 2) will likely draw income assets.

Given the last Fed tightening cycle took the 10yr rate to just 3.2% and that was enough to crash stocks in late 2018 and flip the Fed I see this analysis as a little stodgy.

Moreover, previous episodes of QE taper have also proven quite disruptive, if not enough to flip the Fed.

David Llewellyn-Smith

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