Buoyant stock market raises concerns as real yields soar

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The recent surge in US real yields, which measures bond investors’ expected return after accounting for inflation, has raised concerns among investors. They worry that changes in the Treasury market are undermining a vital support for riskier assets such as stocks.

The yield on 10-year inflation-protected securities (Tips) reached 1.82% on Friday, its highest level since 2009. This increase has led investors to believe that the Federal Reserve will need to keep interest rates high for a longer period to control inflation.

Real yields are closely monitored as they indicate borrowing costs across the economy and help determine the relative value of risky assets. When real yields rise on low-risk government debt, other assets become relatively less attractive to investors. The surge in yields this week surpassed levels seen last October during a sharp bond sell-off and when US inflation expectations were more uncertain.

“There’s a significant risk that this rise in real yields will start to harm the corporate sector,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International. He explains that refinancing debt at much higher rates due to the low interest rate environment could lead to problems for companies.

Ahmed highlights that a typical high yield company that borrowed at around 4% during the pandemic would now have to pay more than 12%. Refinancing under these circumstances can be a major challenge.

Analysts predict that the impact of higher borrowing costs will be felt more strongly in the second half of next year and into 2025, particularly for companies that borrowed to support the economy during the pandemic and face the need to refinance their loans.

Interestingly, lending has already slowed down this year. According to Fidelity, US banks have issued new loans and leases at an annualized rate of $279 billion so far in 2020, compared to an average level of $481 billion between 2015 and 2019.

As financial conditions tighten, investors also grow increasingly concerned about US equity valuations. Jon Day, fixed income portfolio manager at Newton Investment Management, explains that the high return required to beat Tips should theoretically cause equity prices to decline. However, stocks have seen significant gains this year, driven primarily by excitement over the potential of artificial intelligence and investment in large technology companies.

Some investors believe that a strong stock market and worrisome bond investor sentiment cannot both be correct. If real yields remain high, it could have a damaging effect on equities, undermining the optimistic outlook.