The New Hurdle Rate: What 5% Bond Yields Mean for Equity Investors

Thought leadership article from Sean Peche, Founder and Portfolio Manager at Ranmore Fund Management, looking at what materially higher US interest rates mean for equity investors.

With long-term US government bond yields now around 5%, investors face a markedly different environment from the ultra-low interest rate period of recent years. At the same time, US inflation remains above the levels seen in the decade before Covid, while equity valuations and operating margins in parts of the US market are already elevated.

In the piece, Sean examines how this higher-rate environment changes the relative attractiveness of equities, and why valuation, balance-sheet strength and the starting yield available to investors could become increasingly important.

The article covers:

• Why the persistence of inflation since Covid illustrates the difficulty of forecasting macroeconomic variables, and why Ranmore prefers a bottom-up investment approach
• How the rise in long-term US interest rates from below 2% in 2020/21 to around 5% has changed the investment backdrop for companies and investors
• Why higher borrowing costs create challenges for heavily indebted businesses, while cash-rich companies can benefit from higher interest income
• Why a circa 5% yield on long-term US government bonds raises the hurdle for equities, particularly when the S&P 500 offers a dividend yield of around 1%
• Why elevated US operating margins and valuations mean investors may increasingly need continued earnings growth and/or further valuation expansion to generate attractive real returns
• Why lower valuations, higher dividend yields and stronger balance sheets can provide a different starting point in a higher-interest-rate environment

The New Hurdle Rate: What 5% Bond Yields Mean for Equity Investors

By Sean Peche, Founder and Portfolio Manager at Ranmore Fund Management

In 2021, Covid severely disrupted global supply chains, causing inventory shortages worldwide and higher inflation. The US Federal Reserve and economists called this “transitory inflation”, believing that when Covid was over US inflation would fall back down to the ~1.8% average of the prior 10 years.

Five years later and inflation is still nearly double that level at 3.4%. Inflation no longer seems transitory.

This is an example of why we aren’t “top down” investors and don’t try and predict macro-economic variables – there are far too many moving parts in an economy to consistently predict economic metrics and if central bankers can’t get it right with their army of economists, what chance do we have?

It’s why we’re “bottom up” investors, selecting companies based on valuations and their underlying company fundamentals as, we feel, a more reliable way of generating returns.

But while we don’t engage in economic forecasts, we do need to understand the economic environment in which our companies are operating and the impact this may have on their businesses. That’s we are “macro aware” and are presently very aware of the rise in long-term interest rates in the USA from below 2% in 20/21 to 5.2%, the highest in 19 years. The same is said for the rise in 20-year Japanese Government Bond yields from ~0.5% in 20/21 to 3.8%, the highest in 30 years.

High interest rates bring challenges including,

An increased burden on highly indebted companies and governments when lower cost debt matures and is replaced by higher cost debt. In contrast, cash flush companies benefit from earning higher interest income from their cash investments.

Pressure on valuations. Financial assets compete for capital and when you can earn a “risk free” 5% from long term US government bonds or a 2.4% real yield from a 10year US inflation linked bond, a 1% dividend yield on the S&P 500 index look relatively less attractive. To earn a real return, investors need earnings growth and/or a further upward valuation re-rating of those earnings. The challenge today in US markets is that both operating margins and valuations are already at high levels so relying on them to both rise further may be expecting too much.

In comparison, the weighted average dividend yield of our portfolio holdings is around 3% after withholdings tax, requiring lower contributions from earnings growth and re-ratings to generate an attractive return. It is important to note that a dividend yield is more akin to an inflation linked bond yield because if the underlying business can grow its earnings in line or above inflation, the dividend yield is theoretically a real yield. Our companies are not trading at record operating margins, and we think there is some upside potential from their relatively low valuations depicted by the fund’s 9x earnings multiple. Furthermore, our holdings have relatively strong balance sheets, insulating them from these higher interest rates.