As I sit in the office at home, I casually glance at the Nasdaq performance over the last few years and the performance has been startling! In the last five years alone the Nasdaq has more than trebled – significantly outperforming most other indices. The rise has been meteoric and according to some market commentators valuations appear stretched. “But this is a bond blog Simon, so why are you waffling on about equities?” I hear you rightly ask.
Well, the reason I mention the Nasdaq is that as a consequence of its rise and its composition of securities, it now shares a number of parallels and consistencies with bonds. Cashflows from these companies are heavily weighted to the distant future. Investments and growth are more important than the short term reward to shareholders. This fact is illustrated so perfectly with the Nasdaq dividend yield of a measly 0.66% staring at me from my Bloomberg terminal. As a consequence of these back loaded cashflows the index is very sensitive to earnings disappointments, changes in risk premium AND highly sensitive to changes in the opportunity cost of money i.e. interest rates!
There is much excitement in the market chatter about inflation for the first time in a long while. Whilst container ship pricing and semi-conductor prices have been impacted by the lockdown, the opening up of economies is likely to unleash the massive global demand that has been so pent up over the last twelve months. Against a backdrop of disrupted supply chains, and throw in the low investment in traditional energy production over the last few years and there are valid reasons why some are expecting an uptick in inflation in the western world.
US treasury yields, the globe’s effective funding rate, have already risen by circa 30bps so far this year with expectations of significant fiscal stimulus from the new Biden administration and continued easy monetary policy to support growth and jobs from the Federal Reserve. The US 10 year yield now stands at circa 1.2% at time of pixel, already 50bps in excess of that of the Nasdaq index!
So what if treasury yields were to rise another 50bps? And as an addendum, what if equities were to maintain their 50bps differential to treasuries – what would be the impact on them? According to my basic maths, the collapse in the Nasdaq would be cataclysmic. The Nasdaq would have to fall a massive 40% in order to provide investors with a dividend yield of a mere 1.16%!!! A startling thought!
In reality, tech stocks’ revenues are growing and their cash flows are generally expanding too, helping to soften this potential impact and dampen the duration aspect to which I refer. However, there is absolutely no doubt that the rise in these stocks’ valuations that we have seen over the last few years have made them far more bond like and as a consequence, far more sensitive to changes in interest rate rises.
As bond investors at Premier Miton we have the ability to adjust the duration of our funds according to market conditions, whether that be shorter duration to the benchmark or exhibiting little to no duration at all. In times of rising rates high coupon, short duration bonds provide investors with downside protection when they want to hide from duration all the while providing a positive total return.
Only this last week we were able to increase our holding in a dollar BBB security with a duration of under 3.5 and was yielding in excess of 3.2%. If rates sell off 50bps over the year then this bond still yields a positive total return of 1.7%. A far cry from the 40% fall in the Nasdaq.
Food for thought!
