Performance data imply that the domestic market sectors most at risk from rising interest rates and bond yields are utilities, banks, transportation and real estate. Investors should remember, however, that rate sensitivity is a double-edged sword. The stocks that would decline most if rates continue to rise are also those that will rally most in the case that bond yields don't climb as much as expected.
The four sectors were identified by comparing 20 years of subindex performance data against the yield on the Government of Canada five-year bond. The S&P/TSX Utilities Index, the S&P/TSX Bank Index, the S&P/TSX Transportation Index and the S&P/TSX Real Estate Index were found to have the biggest inverse correlation with the bond yield – they moved most consistently higher as yields fell, and dropped when yields rose. There are limitations to this method, particularly in regard to transportation stocks, which we'll discuss further.
The first chart below depicts the performance of the utilities index and the path of bond yields. The inverse relationship is especially apparent in the 1998 to 2005 time frame, when almost every tick in bond yields was accompanied by an opposite move in utility stocks.
The opposing moves are what we'd expect as the usual utility company carries considerable debt (infrastructure is expensive to build and maintain, necessitating continuous financings) and profits are sensitive to borrowing costs. Utility stocks frequently pay larger-than-average dividends, and these payouts are more attractive when bond yields are low, and less valued by investors when bond yields rise.
The second chart compares bank stocks and bond yields. The correlation calculations do not, to me, provide as much guidance for investors. The tick-by-tick mirrored movements from the utilities chart aren't as visible here, and it looks more as though bank stocks have moved consistently higher while bond yields have steadily declined.
The chart itself is not that compelling, but it is true that lower bond yields and borrowing costs increase consumer demand for loans, as real estate markets reflect. This increased loan demand contributes to bank profit growth.
Significantly higher rates would form a hurdle for bank earnings by crimping demand for loans, and possibly causing loan defaults. But the major domestic banks are huge, diversified operations at this point and the chart is not, on its own, sufficient reason to become pessimistic on bank stocks as yields rise.
The third chart compares bond yields and transportation stocks and I don't trust this one at all. The S&P/TSX Transportation Index is dominated by Canadian National Railway and Canadian Pacific Railway, and these are economically sensitive, cyclical companies.
The same growth and inflation pressures that push bond yields higher should increase revenues and profits for the railways. So, if anything, bond yields and transport stocks should be positively correlated. In the last segment of the chart, from the end of 2016 to the present, that's what we see – railway and transportation stocks are rising along with yields. For this reason, I am not at all concerned about the negative effects of rising rates on the transportation index in the shorter term.
The S&P/TSX Real Estate Index has a smaller inverse correlation to yields than banks or transports over the past 20 years, but the case for real estate stocks to weaken as yields climb is stronger in my view. Like utility stocks, real estate operations are highly credit sensitive – profits are derived from the difference between the continuing financing costs of buying a property, and the revenues from rental income. The higher borrowing costs reflected in rising yields directly affect the bottom line for real estate companies over time. Real estate companies can, however, protect profit margins if they can raise rents faster than borrowing costs climb.
The bottom chart shows that so far the real estate index has treaded water, resisted the negative force of rising bond yields. But if the 1998 to 2000 period, or the taper tantrum of 2013 are worthwhile precedents, stock prices and net asset values in the sector are likely to drop if yields continue to rise.
A combination of performance history and business models identifies utilities and real estate as the two areas where rising interest rates would hurt most. The caveat is that the Bank of Canada, thanks to contentious negotiations of the North American free-trade agreement and cooling housing markets, has been making more cautious noises about further rate hikes.
Signs of a slowing Canadian economy (personally, I'm watching monthly retail sales results for signs that high household debt levels are reducing consumer spending) would temper bond yield increases and the risks to real estate and utility stocks would subside. Investors should, however, expect weaker performance in these sectors as long as yields are climbing.