Breaking News
Investing Pro 0
Cyber Monday SALE: Up to 54% OFF InvestingPro+ CLAIM OFFER

Real Yields Spike And The Equity Risk Premium Plunges

au.investing.com/analysis/real-yields-spike-and-the-equity-risk-premium-plunges-200526830
Real Yields Spike And The Equity Risk Premium Plunges
By Mike Zaccardi, CFA, CMT   |  Sep 26, 2022 20:29
Saved. See Saved Items.
This article has already been saved in your Saved Items
 
 
US500
-0.03%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
DX
+0.44%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
US1YT=X
+0.50%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
US2YT=X
-1.14%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
US3YT=X
-1.27%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
US10Y...
-1.81%
Add to/Remove from a Portfolio
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
  • Positive inflation-adjusted return on default-risk-free Treasuries/corporate bonds
  • Higher market rates means a much lower S&P 500 equity risk premium
  • Consider asset allocation tweaks but wholesale changes not warranted

Treasury yields have been on a massive advance. While the bond bear market arguably began more than two years ago, it’s just since early August that intense selling has rendered rates to their highest level in 15 years on parts of the curve. What’s more, expected inflation appears to be cooling off despite a much hotter than expected August CPI report.

Treasuries vs TIPS

Investors can compare rates on conventional Treasuries to Treasury-Inflation Protected Securities (TIPS) to get a sense of where inflation goes from here. There’s a handy dashboard put together by Jeremy Schwartz at WisdomTree that illustrates well how positive the outlook is for owning boring old Treasury bills, notes, and bonds.

The chart below shows the TIPS yield curve—basically the inflation-adjusted rates of return you can currently capture on Treasuries. Notice that they are positive across the maturity spectrum. Moreover, real yields on short-term Treasuries, under five years in maturity, are particularly positive.

TIPS Yield Curve: In the Black After Years in the Red

TIP Yield Curve
TIP Yield Curve

Source: WisdomTree

Higher yields on default-risk-free fixed income is not just an ‘oh that’s interesting’ story of the market. It has big implications for the value of equities. As the yield on the U.S. 10-year Treasury note increases, that raises the cost of capital for many firms. Finance 101 teaches that when the cost of debt financing shoots up, investment projects become pricier. Also, consider that a higher safe bond yield makes stocks look relatively more expensive for investors.

The S&P 500 Equity Risk Premium Falls to 14-Year Lows

The equity risk premium, or the earnings yield on the S&P 500 minus the 10-year Treasury rate, has fallen to its lowest level since 2008. What’s that mean? Well, perhaps stocks are not much of a bargain despite the 22.5% plunge so far this year.

Higher Interest Rates = Lower Equity Risk Premium

S&P Cost of Equity
S&P Cost of Equity

Source: Goldman Sachs Investment Management

With the so-called “TINA” (there is no alternative) trade seemingly dead now that we can snatch up a 2-year Treasury note at 4.2% or buy the iShares iBoxx Investment Grade Corporate Bond ETF (NYSE:LQD) with a whopping 5.4% yield to maturity, should you make wholesale changes to your asset allocation?

Rethinking Your Portfolio?

This is actually something I’ve been thinking about. I think we can all agree that fixed income yields today, assuming the inflation outlook is roughly correct, are enticing for certain investors. What makes dipping your toe into bonds so hard is that they just keep falling in price! Today’s intriguing rates might be far better a month from now if the global fixed-income selloff keeps at this pace.

Catching the Falling Fixed Income Knife

Just in the last 35 trading days, take a look at the carnage across credit markets. The “long bond” is down more than 11% (including dividends) while corporates are off about 8%. Short-term 13 year Treasuries, despite their strong current yields, are down almost 2%. Foreign fixed income has also taken a beating with a 5.6% total return loss in that time as the U.S. dollar soars. A true bond bloodbath.

Investors Bail from Bonds

SHY ETF
SHY ETF

Source: Stockcharts.com

I won’t be making major changes to my portfolio, but I will ensure my emergency fund cash earns north of 4% via short-term Treasuries. Also, consider that money market mutual funds now yield about 2.8% following last Wednesday’s Fed rate hike—those funds will likely pay out close to 4.5% at some time next year based on Fed Funds futures.

The Bottom Line

Stocks might not be as cheap as you might think. A feature of this bear market is that interest rates have surged, not collapsed. That means the cost of capital effectively rises for corporations while the equity risk premium for investors has dropped hard. What a difference a year makes.

Disclaimer: Mike Zaccardi does not own any securities mentioned in this article.

Real Yields Spike And The Equity Risk Premium Plunges
 

Related Articles

David Bassanese
Twilight zone By David Bassanese - Nov 28, 2022

Week in review The third ‘Fed pivot’ trade this year – which essentially has been in place since mid-October – continued last week, with markets still basking in the growing...

Real Yields Spike And The Equity Risk Premium Plunges

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Don’t Monopolize the Conversation. We appreciate passion and conviction, but we also believe strongly in giving everyone a chance to air their thoughts. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Continue with Google
or
Sign up with Email