[TOP STORY] The 5% bond yield reality

Sean Kelly (0:02)

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Simon Brown (0:05)

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Chatting now with Sean Kelly from Parity Wealth. Talking US bonds. I mean, the 10 years one we all watch currently at 5.31, but even the 5 years now above 5%, as is the 7, didn't know there was a 7 year bond, the 10 and of course the 30 year, I should 5.68. Sean, I appreciate the early morning time. US yields above that 5% level.

What's driving them higher and how should investors see this perhaps from the more important question? Is this a warning sign? Is this an opportunity? Is this perhaps a bit of both?

Sean Kelly (0:45)

Morning, Simon, and always great to go on. And I think the big change is that the bond investor is now finally being paid again. As you say, the US treasury yield is sitting at around 5.3%, which is the highest level we've seen in about 24 years. And compare this with that 2022, when it got as low as half a percent and there was roughly 18 trillion of negative yielding debt around the world. Investors were literally paying governments to borrow their own money.

And in that world, we said it was an acronym TINA. There is no other alternative. But to date, for more than 5%, there very clearly is one. But what's interesting is why long-term yields have stayed this high, even as the markets talk about slower growth, fair cuts and inflation. I think inflation explains part of it, but not all of it. The bond market is only pricing in inflation in the mid 2% range, which means investors are now demanding a real return of roughly 3% to lend long-term. And you can understand why the US federal debt is above that $40 trillion mark, and the interest payment alone is around $1 trillion a year.

Additionally, AI is competing for that same pool of capital. So I think investors are simply saying we want to be properly compensated. However, I will caveat all of this by saying, I don't think 5% is necessarily telling us something is about to break. It's telling us the price of money has changed. And when that changes, the hurdle rate for every other investment changes with it.

Simon Brown (2:19)

And that's a good point about not breaking. You know, 5% is a lot, but it used to be the norm. And in fact, if we go back far enough, 5% would have been a low yield. It's just, it feels weird.

I keep on forgetting about those negative yields, which still boggled the brain, but I get it. So then, if investors can earn 5% from a US government bond, essentially, let's call it risk-free in US dollars. That is a really, really nice looking return. What does that do for the investment case and valuations for equities? It must take some shine off the equity, because, I mean, not everyone wants the 5%, but certainly there's some folks who are gonna say, yeah, I'll take that.

Sean Kelly (2:52)

Absolutely, Simon. I think if you look at the S&P trading in about 19's forward earnings, which is an earning yield of roughly 5.2% versus 5.3% on a 10-year treasury, on that crude measure, you're paying almost nothing for extra, owning extra, not paid extra for owning equities. Of course, it isn't apples to apples because equities give you earnings growth. And as we know, those earnings have been very strong, 30% year on year. So every time I look at an expensive share, I have to ask the right questions now, which is, how much additional am I being paid for that extra risk? And that matters most for growth stocks because higher discount rates reduce what distant earnings are worth today.

But 5% yields don't automatically mean equities must fall. In fact, we saw yesterday that the S&P 500 and NASDAQ hit closing highs because AR-related earnings remain extremely strong.

So, I think they're two forces pulling opposite directions. Higher rates are pressing on valuations and strong earnings are supporting prices. However, if earnings disappoint while these yields stay above 5%, those valuations then become much harder to justify.

Simon Brown (4:12)

Yeah, and I like your point because we got, as you said, US markets last night closed all-time highs and bonds at 20-year highs and they can do that. Last question, does this change how we should think about our portfolios and implications potentially, particularly for South African investors?

Sean Kelly (4:31)

Well, I think bonds deserve a much bigger seat at the table now, but it doesn't mean sell equities by bonds. Investors, I think, have simply regained a choice. At over 5%, you can now earn meaningful income from a high-quality asset with potential capital upside. And just as an illustration, if the 10-year yield does fall by 1 percentage point over the next year, the total return would be around 13%. But importantly, although treasuries are safe from credit risk, they still have that price risk. And we saw this in 2022 when long-dated treasuries lost around 30%.