When Bond Yields Rise, Expensive Shares Need to Work Harder

When government bonds offer a meaningful yield, the investment choice becomes more demanding.

Shares are no longer competing with cash or bonds paying next to nothing. They must compete with an asset offering a stated stream of payments, backed by a government and available without relying on corporate earnings growth.

That does not automatically make shares unattractive. It does mean their price, expected growth and risks deserve closer examination.

Bond yield and earnings yield are not the same thing

A bond yield describes the return associated with a bond's price and promised payments. If the bond is held to maturity and all payments are made, the investor has a clearer idea of the nominal return available.

An earnings yield is different. It divides a company's earnings per share by its share price. It is also the inverse of the price-to-earnings ratio.

For example, a company trading on a P/E ratio of 25 has an earnings yield of 4%:

Earnings yield = 1 ÷ 25 = 4%

This makes earnings yields useful for comparing valuations with bond yields. But the 4% is not a payment promised to shareholders. Earnings can fall, management may reinvest them, and the valuation investors are willing to pay can change.

The comparison is therefore a starting point, not a verdict. My guide to earnings yield versus bond yield explores this distinction in more detail.

The missing piece is growth

Suppose a long-term government bond has a higher yield than a company's current earnings yield. On the surface, the bond may appear more attractive.

However, a bond's payments are normally fixed, while a successful company can grow its profits, dividends and value over time. A low earnings yield may be reasonable if the business can reinvest effectively and produce substantial future growth.

This is the central argument supporting highly valued growth shares. Investors are accepting a modest yield on today's earnings because they expect tomorrow's earnings to be much larger.

The difficulty is that expectations can already be reflected in the price. A strong business is not automatically a strong investment at every valuation. If the price assumes rapid growth for many years, even respectable results may disappoint.

When analysing a richly valued company, useful questions include:

• How much earnings growth is required to justify the valuation?
• How long must that growth continue?
• Can the company reinvest capital at attractive rates?
• Are its margins and competitive position likely to endure?
• What happens to the valuation if growth is merely good rather than exceptional?

What the equity risk premium tells us

Investors generally expect shares to offer a higher potential return than a risk-free asset because corporate profits and share prices are uncertain. This extra expected compensation is known as the equity risk premium.

A rough shortcut is to subtract the government bond yield from the market's earnings yield:

Earnings-yield spread = earnings yield - government bond yield

A narrow or negative spread suggests investors are relying heavily on earnings growth, dividends, buybacks or a continuing high valuation to produce an attractive return.

This shortcut is incomplete, however. It treats current earnings as though they will remain unchanged and ignores how companies distribute or reinvest cash. More developed equity-premium models consider expected growth, cash returned to shareholders and long-term interest rates. Professor Aswath Damodaran publishes market data and implied equity risk premium estimates illustrating this broader approach.

The key lesson is not that every share must have an earnings yield above the government bond yield. It is that investors should understand what must happen for a lower-yielding share to compensate them for taking more risk.

Why growth shares are sensitive to interest rates

A company's value reflects the present value of the cash investors expect it to generate. The further into the future those cash flows sit, the more sensitive their present value is to the discount rate used.

Growth companies often derive a large part of their estimated value from profits expected many years ahead. When the risk-free rate rises, the hurdle rate applied to those future profits also tends to rise. All else being equal, their present value falls.

This can reduce the valuation multiple investors are willing to pay even if the underlying company remains profitable and operationally successful.

The reverse can also happen. Earnings may grow into a previously demanding valuation, allowing the P/E ratio to decline without requiring the share price to fall. This is why it is worth understanding how earnings can catch up with the market.

Long-term bonds carry risks too

Describing government bonds as a risk-free benchmark can hide important distinctions.

The term usually refers to the assumed ability to make payments in the bond's own currency. It does not mean the bond's market price cannot fall. Long-dated bonds can be particularly sensitive to interest-rate changes. If yields rise after purchase, an existing bond with a lower coupon may lose market value.

Inflation can also reduce the purchasing power of fixed payments. A high nominal yield is less appealing if inflation remains high over the holding period.

Comparisons should therefore account for the investor's time horizon, inflation exposure and whether the bond is likely to be held until maturity.

Diversification reduces the need to make one big prediction

A higher bond yield can improve the range of choices available to investors. Bonds may provide income and behave differently from shares under some market conditions, while equities retain the potential to participate in long-term business growth.

The purpose of diversification is not to identify the single asset that will perform best next year. It is to avoid making an entire portfolio dependent on one outcome, such as falling interest rates, uninterrupted growth-stock leadership or persistently low inflation.

The SEC's guide to asset allocation, diversification and rebalancing explains how combining asset classes can reduce reliance on any one type of investment.

Diversification also matters within equities. A portfolio dominated by a small number of highly valued companies can contain more valuation and business-model concentration than its number of holdings suggests.

Focus on the return assumptions, not the headline

A bond yield and an earnings yield may look directly comparable, but they represent different things. One is linked to contractual payments. The other is a snapshot of uncertain corporate earnings relative to price.

Higher risk-free rates raise the opportunity cost of owning expensive shares. They also reduce the margin for error when a valuation depends on distant growth.

The sensible response is not an automatic switch from shares to bonds. It is to examine the assumptions embedded in each investment, recognise the different risks involved and build a portfolio that does not require one narrow forecast to be correct.