When the Bank of Canada starts raising rates, will that spell the end of the run for yield stocks?
Analysts at Macquarie say no, arguing that rates could climb significantly before putting meaningful pressure on the valuations of yield stocks.
For starters, whatever Bank of Canada Governor Mark Carney and his team do to raise rates, it will be gradual.
Moreover, the Macquarie analysts argue the Bank of Canada overnight rate has limited impact on longer-term bond yields, which are also important for yield-stock valuations. In fact, there's a chance that long bond yields decline further even if the Bank of Canada boosts short rates.
"While even a gradual tightening cycle should put upward pressure on Canada’s 10-year bond yield, we believe this should be limited due to its tight relationship with the U.S. 10-year and the likelihood of weaker growth in the U.S. in the medium-term," said Macquarie. "What’s more, with sovereign debt potentially becoming a concern in the years ahead in the U.S., it’s possible that Canadian government bonds receive additional safe haven flows, placing further downward pressure on yields, despite a rate tightening cycle."
Macquarie estimates that the 10-year bond yield could climb as much as a full percentage point before having a "material impact" on the valuations accorded to yield stocks. That's because there's actually a cushion built into valuations, with yield sectors trading at relatively higher yields than usual compared with corporate bonds. And those corporate bonds are also offering a significant yield spread over the 10-year, relative to historical levels. "This indicates that in any risk-on environment the yield sector valuations are likely to withstand a 75–100bp rise in the 10-year bond before looking relatively expensive," Macquarie argues.
Some of Macquarie's top picks in yield stocks are Telus Corp. (T-T), Toronto-Dominion Bank (TD-T) and Boardwalk REIT (BEI.UN-T).
It's worth keeping in mind that Macquarie specializes in yield stocks, so the firm has to be hoping that the market for what it sells doesn't get hit too hard.