Bank of America says investors might start selling stocks and buying bonds sooner than expected. Here's when it could happen, and what to own for maximum income if yields keep rising.
- Savita Subramanian of Bank of America says a big shift from stocks to bonds might be close at hand.
- She says income-focused investors will have to make changes when that happens.
- She explains the sectors and types of stocks that will be most appealing in that environment.
- Visit the Business section of Insider for more stories.
What’s the point of bonds for an investor today?
After more than a decade of ultra-low bond yields and ultra-low interest rates — the lowest in centuries or longer, according to some analyses — more investors have turned to stocks for the stability and income they once expected from bonds. And they’re still relying on stocks for growth.
Savita Subramanian, Bank of America’s head of US equity and quantitative strategy, says that might change sooner than a lot of investors think. While Treasury yields today are too low to meet a lot of investors’ needs, she says that by the end of 2021, they could rise to a level that convinces more people to pull money out of the stock market.
“Our rates strategists’ forecast for a 10-yr yield of 1.75% by year-end renders TINA less compelling,” she wrote, referring to the saying that “there is no alternative” to stocks with yields so low.
On Thursday, the yield on the 10-year Treasury note was about 1.14%. Subramanian says that if that yield reaches 1.5%, more experts will recommend that investors reduce the amount of stock in their portfolios.
“Following the GFC, the average recommended stock allocation was ~50%, well below the current recommended allocation of 58.4%,” she wrote in a note to clients.
Today, about 70% of the companies on the S&P 500 have dividend yields that are higher than the yield on the benchmark Treasury note, and the index itself has a greater yield. But Subramanian says that would change if Bank of America’s forecast proves correct.
Subramanian acknowledges that this flow of money from stock to bonds might not happen until the 10-year hits higher levels. A 10-year yield of 3%, for example, would make Treasuries competitive with the implied 10-year price return of the S&P 500 based on its price to normalized earnings ratios, she says.
But whenever it happens, it’s going to remake some patterns in the market that have persisted for more than a decade, and an investor looking for income might want to prepare for that now.
What to do
Subramanian said the higher-rate environment would be difficult for low-volatility stocks and for stable dividend payers.
“Long duration growth stocks that benefited from a falling discount rate could suffer a reversal of fortune,” she said. “Short duration high-coupon stocks with no room to raise dividends would pale relative to bond income.”
If those circumstances will hurt both growth-oriented long-term strategies and shorter-duration, high-income-oriented strategies, she says investors should look for a blend of the two.
One component of that approach is investing in companies that can report solid dividend growth rather than the highest absolute payouts. If all the companies of the Russell 1000 index were ranked by their yields, she says the best choices for that approach are just outside the top 20% of highest payers and fall between 21% and 40%.
“Dividend growth stocks with inflation- and rising-rate protected yield (often found in Quintile 2) will likely draw income assets,” she wrote. “Quintile 2 stocks generally sport lower payout ratios and higher dividend growth prospects.”
Subramanian says focusing on that second quintile will help investors steer clear of stocks that look like they have high yields only because their prices are plunging, and allows them to benefit from price gains for fast risers. That means that group has strong risk-adjusted returns.
Subramanian adds that financials are easily the best-performing sector in a rising interest rate environment, as banks and other financial companies become more profitable. She says chipmakers also benefit, while energy companies and tech hardware stocks are expensive and are hurt by higher rates.
She adds that the biggest individual beneficiaries would include chipmaker Qorvo, data center real estate firm Equinix, casino and resort operator Las Vegas Sands, equipment rental company United Rentals, and SBA Communications, a wireless infrastructure real estate investment trust.
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Get the latest Bank of America stock price here.
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