Why Bad News for Bonds Might Be Good News For the Stock Market

Since the election, interest rates have been rising around the world. This is bad news for bond holders who have suffered losses of more than $1 trillion according to some estimates. When writing about interest rates, authors often note that bond prices move inversely to rates.  When rates rise, prices fall. That’s about as far as the discussion goes. Instead of stopping there, we would like to put some specific numbers to the idea.

Since the election, the interest rate on the ten-year Treasury note has moved up by almost 0.5%. The ten-year yield is the most commonly cited long-term interest rate. Over that time, the price of iShares 20+ Year Treasury Bond (NYSE: TLT) has fallen by more than 7%. TLT is an ETF that is widely held by investors seeking exposure to long-term government bonds. A popular corporate bond holding, iShares Core US Aggregate Bond (NYSE: AGG), has fallen in value by 2.5%. Over the past several months, the losses are even larger.

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While large losses always seem to bring out bargain hunters, there is no sign that bonds offer a bargain yet. The chart pattern indicates the losses in bonds could continue for years. The long-term chart shown below shows the first price target on the downside is more than 12% below the current price.

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At the target price, investors in TLT will have lost more than a quarter of the value of their holding if they owned the ETF when it reached its all-time high less than four months ago.

To put recent losses in perspective, the losses in AGG are equivalent to more than one year’s worth of interest payments. In TLT investors have lost principal equal to almost three years’ worth of interest payments. These are large losses in relative terms.

Investors have been told for years that when rates rise, prices fall but it doesn’t seem like the magnitude of the losses has been clearly explained. Now, there is no need to explain the risk because investors are watching the damage unfold in their portfolios. Some investors may not realize they’ve suffered large losses yet since they may be long-term investors who only check their accounts once a month or once a quarter. These investors are also likely to believe their investments in bonds were safe and large losses were unlikely. Once they see the risks are rather high and the potential returns of yields less than 2.5% are rather small, they may take action to change their portfolio allocation.

Bonds could keep losing value if rates continue to rise as inflation fears grow. Historically, bonds have offered yields equal to the rate of inflation plus a premium equivalent to a rent payment the bond holder pays to the bond buyer for use of the money. Higher inflation results in higher yields using history as a guide.

Concerns are rising that the new administration could take actions that are inflationary. Inflation could result from good or bad reasons under the new administration.

Increased deficit spending could be considered a bad reason for higher inflation and some economists warn that is possible. Other economists cite good inflation as a likely outcome of the new administration’s policies since their plans could increase economic growth and lead to higher wages. It’s important to remember that central banks around the world, including the Federal Reserve, have been trying to spark good inflation of 2% or so telling us this is needed to increase wages. Whether it results from fiscal policies of Trump rather than monetary policies of the Fed isn’t important to investors.

What is important to investors is how markets react. Continued losses in bonds could push investors out of bonds and into stocks. If inflation does start to rise, bond market investors will be faced with the certainty of additional losses. In that case, investors might choose to buy dividend-paying stocks that offer the potential for gains in addition to income.

With this risk growing in the market, now could be the time to look at high income stocks that provide some safety. To find some possible investments, we screened for large cap stocks with high yields and low price-to-earnings (P/E) ratios. Large cap stocks are big companies that usually have a degree of safety because of their size. Low P/E ratios point us to value stocks and high yields offer income. Some of the names we found are familiar.

The car and truck maker Ford Motor Co. (NYSE: F) offers a dividend yield of about 5%. The dividend payout of $0.60 a year is well covered by earnings which are expected to $1.81 per share this year and about $1.64 next year. F also has free cash flow of $2.24 per share. Free cash flow is the amount of cash that a company has left over after meeting its operating expenses and making necessary investments in the business. When free cash flow exceeds the dividend payment, the dividend is generally safe. Although F will see its earnings rise and fall, it is likely the stock’s dividend will continue to provide generous income to investors.

Entergy Corporation (NYSE: ETR) is an energy company. The company provides electric power to retail and wholesale customers in areas of Arkansas, Mississippi, Texas and Louisiana, including the City of New Orleans and operates a natural gas distribution business. ETR also offers a dividend of more than 5%. Its annual payout of $3.48 is covered by earnings. As a regulated utility, the company is generally allowed to make a reasonable profit and to continue rewarding shareholders with a reasonable dividend. The company has paid a dividend every quarter since 1988 and is unlikely to cut its dividend with a history extending back almost thirty years.

Seagate Technology plc (Nasdaq: STX) is one of the largest manufacturers of hard disk drives (HDDs) in the world. In addition to HDDs, it produces a range of electronic data storage products, including solid state hybrid drives, solid state drives, peripheral component interconnect express (PCIe) cards and serial advanced technology architecture (SATA) controllers. STX’s earnings have been in decline since the first quarter of 2013.  Earnings are shown as the solid line in the chart below.

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Analysts expect earnings per share (EPS) to stabilize near $3.60 for the next three years. This is an amount sufficient to meet the company’s annual dividend payment of $2.52 a year. At the current price, STX provides a yield of more than 6.5%.

Pitney Bowes Inc. (NYSE: PBI) provides global eCommerce solutions, shipping and mailing products, location intelligence, customer engagement and customer information management solutions. The company may be best known for its postage meter systems that are used in many small offices. There is growing competition in this field but there is also growing demand in this field. Analysts believe PBI will continue to maintain significant market share and to grow EPS. This year, analysts expect EPS of $1.73 and they expect EPS of $1.94 next year. The annual dividend payment of $0.75 seems secure and the current yield of 5% should be attractive to income investors.

The truth is we never know what the first year of a new Presidential administration will bring. But after a 35-year bull market, a bond market decline is certainly possible. If there is a shift to income stocks, F, ETR, STX and PBI could be among the winners. If the bull market in bonds continues, these stocks could also be winners and their income could be even more attractive if rates remain low.