Strategies for a Rising Rate Environment
- By Dilantha De Silva
Bond yields are rising, and that is not a welcome sign for stock market investors. Even though the relationship between bond yields and stock prices tends to vary at different stages of the business cycle, these two variables usually exhibit a negative correlation, suggesting higher bond yields will lead to lower stock prices. That being said, many other factors need to be taken into consideration before deciding on the best course of action, or whether any action needs to be taken at this point.
The recent developments
In the first week of February, the 30-year treasury yield crossed the important 2% mark for the first time in over a year, signaling that bond traders are turning bullish on the U.S. economy. As illustrated below, the 10-year treasury yield has also been climbing since last July and is currently over 1.3%.
Source: MacroTrends
In response to this steady rise in yields, all the major stock market indexes in the United States have lost some gains in the last couple of trading sessions, and experts are predicting this phenomenon to continue. Commenting on how a small bullish movement could lead to a substantial increase in yields, head of Bianco Research Jim Bianco told Bloomberg:
"You get a little bit of a turn, then more of a turn, then pow! It just goes. It will also be unsettling because, remember, who's the biggest buyer of real yields? The Federal Reserve. They own 20% of that market."
Commenting on the recent spike in yields, FXTM chief market strategist Hussein Sayed said:
"The recent rally seen in yields reflects mainly two things. One is we are finally beating the virus and hence we are headed for strong economic activity. The second part which worries many investors is that inflation may return at a faster pace than previously anticipated. A steady slow increase may not necessarily disrupt the uptrend in equities but will likely force rotation from highly-priced stocks, typically in the tech sector, to more reasonably priced cyclical ones. But another sharp spike in bond yields, in which the 10-year approaches 1.75% in a short time frame could pose a big risk to the bullish trend in the overall equity market."
Failure to account for the risks posed by an unexpected rise in interest rates and treasury yields could hurt investors in the long run, so investors may want to deploy a few strategies to mitigate this threat.
How to hedge against interest rate risk without selling equities
Divesting equities in favor of other income-producing assets is the easy choice in an environment that does not favor stocks, but jumping onto such a conclusion today could prove to be costly. Even though bond yields will rise along with the expected revival of business activities, corporate earnings are also likely to increase in the coming quarters. As a result, high-quality companies operating in fast-growing business sectors are likely to see strong momentum behind their shares in the market.
Investors who succumb to fear of a market crash will miss out on very lucrative opportunities. As Peter Lynch famously said, "the real key to making money in stocks is not to get scared out of them," and investors need to find ways to mitigate the risks of rising yields while getting enough exposure to stocks. Luckily, there are many ways to achieve this objective.
First, I think it would be a prudent decision to trim the exposure to the booming housing sector, even though the industry continues to benefit from secular macroeconomic trends. Stock prices of many home construction companies including Lennar Corporation (NYSE:LEN), D.R. Horton, Inc. (NYSE:DHI) and Green Brick Partners, Inc. (NASDAQ:GRBK) have delivered multibagger returns since last March, and it might be a good time to consider booking some profits in expectation of a rise in mortgage rates. The 30-year fixed mortgage rate has already risen to 2.81% from 2.73% a week ago, and Freddie Mac chief economist Sam Khater said:
"Economic spending has improved due to the most recent stimulus, but supply chain shortages are causing downstream inflation, leading to higher mortgage rates. While there are multiple temporary factors driving up rates, the underlying economic fundamentals point to rates remaining in the low 3% range for the year."
The housing industry will not come under any severe pressure, but now is not the time to be investing in this sector either.
Second, investing in the undervalued banking sector could help investors mitigate some of the risks associated with rising yields. For the best part of the last 12 months, banking stocks remained under pressure as a result of the ultra-low interest rates that prevailed in the United States. In the recovery phase, things are likely to reverse in favor of the financial services sector, and exposure to big banks such as Bank of America Corporation (NYSE:BAC) will help generate alpha returns in the coming years. It is no secret that net interest margins will rise along with an increase in policy rates and treasury yields, so now is the best time to tactically allocate assets in this troubled business sector.
Third, it would make sense to limit exposure to companies with an international presence as the U.S. dollar will strengthen if rates rise. The positive correlation between policy rates and the greenback will dictate terms in the coming months if yields continue to rise, and this is bad news for companies that generate a significant portion of their revenue in international markets. The best approach is to find attractively priced small-cap stocks that are generating the bulk of their revenue domestically as an adverse movement in foreign exchange rates will not affect these companies to a meaningful degree.
In my view, the strategies highlighted in this segment will help investors negate some of the risks of rising yields without having to run away from stocks, which seems to be the correct approach considering the strong growth in corporate earnings expected in the second half of this year.
Takeaway
Bond yields are rising, and this has a lot to do with the improving sentiment of investors toward a full recovery from the virus-induced recession. The rollout of vaccination programs in key regions of the world such as North America, Europe and South Asia have helped reduce new infections, and this success has played a role in rising yields. Although stock prices will likely retreat in the short term, there is no reason to panic. The best course of action, in my view, is to gain exposure to business sectors that will thrive in a rising rate environment.
Disclosure: The author owns shares in Green Brick Partners.
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This article first appeared on GuruFocus.
