Rising Real Yields Threaten High-Yield Companies’ Share Prices

A surge in US real yields, reflecting the return on bonds adjusted for inflation, has raised concerns among investors about the implications for riskier assets such as stocks. The yield on 10-year inflation-protected securities (Tips) reached 1.82% on Friday, the highest level since 2009, as investors increasingly anticipated the Federal Reserve maintaining higher interest rates to combat inflation.

Real yields serve as a vital indicator of borrowing costs throughout the economy, influencing the relative attractiveness of risky assets. The recent surge in real yields has made low-risk government debt more appealing, thereby diminishing the attractiveness of other investment options. This rise in borrowing costs is reminiscent of last October when bonds experienced a sharp sell-off, coinciding with a period of greater uncertainty surrounding US inflation.

The repercussions of this increase in real yields pose a significant risk to the corporate sector. Debt acquired when interest rates were at or near zero may now require refinancing at much higher rates. Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, explains that the problem arises when companies need to refinance debt that was initially borrowed in a low-interest rate environment.

For instance, a high-yield company that secured funding at around 4% during the pandemic may now face interest rates exceeding 12%. The impact of this sudden increase in borrowing costs could be severe for these companies as they grapple with the financial burden of refinancing their debt at significantly higher rates. Such a shock to the financial system can exert downward pressure on the affected company’s share price, potentially leading to increased volatility in the equity market.

Furthermore, analysts anticipate that the effects of higher borrowing costs will be more acutely felt in the latter half of next year and into 2025. Many companies took advantage of slashed interest rates during pandemic lockdowns to secure loans, supporting the economy. However, with lending already slowing down this year, the tighter financial conditions resulting from rising yields may amplify the challenges faced by businesses.

The implications of these shifting monetary and financial conditions are not limited to individual companies. Investors are growing increasingly concerned about US equity valuations as financial conditions tighten. The relationship between stock prices and returns compared to Tips is changing. Jon Day, fixed income portfolio manager at Newton Investment Management, highlights the need for higher equity returns to match the rising real yields. The disparity between expected equity returns and the current market conditions is a significant factor behind the recent stock sell-off triggered by the Fed minutes.

While equities have experienced substantial gains this year, largely driven by investor enthusiasm for companies leveraging artificial intelligence, some investors question whether a buoyant stock market and apprehensive bond investors can both be correct.

Overall, the surge in US real yields carries substantial implications for various aspects of the financial landscape. The shock of higher borrowing costs for companies that raised funds at lower rates during the pandemic can significantly impact their share prices.

Additionally, the slowdown in lending, coupled with tightening monetary and financial conditions, raises concerns about the valuation of companies. As investors grapple with these uncertainties, the relationship between stock prices and real yields becomes a crucial factor to watch in the coming months.