What 5% bond yields mean for stock market investors

Nothing good happens above 5%. This is how one of my colleagues recently framed the risks for the equity market if bond yields stay above this watershed level.

It’s a catchy summary of the challenge for stock markets today, as bond yields on both sides of the Atlantic have moved into this danger zone - but it is a simplification. And it does not explain why shares remain close to their all-time high, successfully scaling the bond market wall of worry.

• Looking for personalised financial advice? Our advisory service can help you plan for your next step.

Persistently high bond yields are bad for shares. They eat into company profits via higher borrowing costs. They reduce consumers’ spending power. They offer investors a less volatile alternative to equities. They are a particular problem for companies promising a long pipeline of earnings, because they discount these future profits more aggressively, reducing their present-day value.

The high growth companies caught in this valuation trap are big and important. It is why the Magnificent Seven have drifted for the best part of a year now. But these companies do not tell the whole stock market story. There are alternatives within the equity market that can live more easily within a less yield-friendly environment. The trick is to balance the equity portion of our portfolios towards them.

To do this, I am focused on five characteristics, all of which point in the same direction - away from distant, uncertain earnings streams and towards cash flows that are large, visible and distributable. What you might call jam today.

My first preference, then, is for lots of free cash flow today rather than the promise of earnings growth tomorrow. This is not the same as buying shares that look cheap. A company like Microsoft offers growth, and is not particularly cheap, but it throws off cash now as well as in the future. The dividing line is not really between growth and value, but between profits being generated today and profits whose value depends on what happens many years from now.

Fortunately, there are plenty of factor-focused ETFs which explicitly screen on cash flow and other valuation measures. iShares has one - the World Value Factor ETF - that picks about 400 companies from the MSCI World index that look undervalued relative to a range of fundamental measures. It trades on about 17 times earnings, meaningfully cheaper than the rest of the market.

It is a way of gaining a global equity exposure but without the expensive, high-growth shares most at risk from today’s high-yield environment.

Second, I expect dividends and buybacks to become more highly prized in the new world of competitive bond yields. When interest rates were close to zero, investors preferred to see cash reinvested than distributed. Going forward, many of those potential investments will not stack up. What will matter increasingly is shareholder yield - dividends plus the effect of share buybacks.

The challenge here is to avoid the high dividend trap, where a stagnant, leveraged company pays an unsustainable income. I prefer a lower, but reliable, dividend that can grow over time. Again, there are both actively managed funds and passive ETFs focused on delivering this growing income. Wisdom Tree has a Quality Dividend Growth ETF.

The third characteristic I am looking for in a higher-inflation environment is pricing power. We need companies that can reprice their revenues faster than their costs rise. This is hard to spot quantitatively. It is not an accounting ratio. And it may be where an active stock picker earns their keep over a passive fund.

Morgan Stanley and - full disclosure - my employer Fidelity have Global Brands funds which explicitly focus on intellectual property and pricing power. There is another important trap to avoid here. Pricing power is often associated with the quality investing style and that can too easily become ‘quality at any price’. Pricing power with cash generation and a reasonable valuation is the goal.

Where quality is an important consideration in a high yield environment is with regard to a company’s balance sheet. Persistently high yields expose the companies that could easily refinance themselves when money was cheap, but which struggle when capital once again has a cost. Refinancing a 2% bond at 6% is as painful for a company as a homeowner. And the pain comes with a lag. Companies that borrowed cheaply for five or ten years have been insulated, but every refinancing resets their cost of capital. The ideal, here, is a company that receives interest rather than pays it.

Which leads to the final consideration - geography. The US is more heavily valued on jam-tomorrow profits. Much of its value rests on technology and anticipated future growth. Exactly the characteristics I am leaning away from.

The UK is almost the opposite. With an exposure to financials, energy, commodity-related businesses and high dividend payers, our home market is potentially in the value sweet spot, despite the obvious challenges facing the domestic economy.

Europe and Japan also contain many mature, cash-generative industrial, financial and shareholder-return-focused companies. Japan, in particular, offers several elements of this jam-today investment approach in one place. Reasonable valuations, cash-rich balance sheets, improving capital allocation and growing buybacks and dividends. Japanese companies are consciously moving excess balance sheet cash into shareholders’ hands.

Reshaping the equity share of a portfolio is a way of maintaining a long-term exposure to the best performing asset class over time while becoming less vulnerable to the risk that a rising cost of capital might bring this mature bull market to an abrupt end.

In a world where capital once again has a meaningful cost, it simply recognises the prudence of receiving our investment return sooner rather than later. Some good things can still happen above 5%. But you have to look harder to find them.

This article was originally published in The Telegraph.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: Why the rising cost of capital matters for investors
• Read: Rathbone Global Opportunities: a tried and tested approach
• Read: Triple Lock: what will the State Pension be in the future?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.