The better than expected US jobs report released last Friday has strengthened the case for a long-awaited increase in US interest rates. Although a rise in interest rates will certainly be a short term negative for equity markets globally, the strengthening US economy is a positive and a rate rise should not be viewed completely as a negative.
So how will this impact equity investors in Australia?
While it is not exactly clear what impact the rate hike will have on the Australian equity market in the long term, it certainly will change the dynamics between bond and equity markets around the world.
Not surprisingly, bond markets around the world are moving in anticipation of a rate rise in December. The Australian bond market is no exception with Commonwealth Government bond yields rising sharply on Monday.
The effect of rising bond yields will have the biggest impact on stocks that are high yielding. These high yielding stocks become less attractive compared to bonds when bond yields start to rise.
The opposite is also true. With Australian bond yields falling to record lows following the fall in interest rates over recent years, equities became relatively more attractive as they offered the potential for better yields.
As a result, investors piled into the stocks that had the perception of having bond-like qualities, namely infrastructure stocks, to boost their income returns.
Infrastructure stocks typically offer a defensive stream of earnings that are highly predictable and it has been this predictability that has made the sector attractive to risk-averse investors over the last couple of years.
The question investors now need to ask is whether or not these defensive infrastructure stocks can continue to outperform the market with the potential for bond yields to rise further?
The outlook for these stocks is certainly looking less bullish considering the great out-performance already experienced and the threat of rising bond yields.
For example, Sydney Airport Holdings Ltd (ASX: SYD) has seen its share price increase by more than 60% over the past two years but has fallen nearly 7% over the past week. The forecast unfranked dividend yield is now 4.3% for the financial year (FY) 2016.
Toll road operator Transurban Group (ASX: TCL) has experienced a similar increase in its share price with a 50% increase over the past two years. Although the share price has fallen by more than 5% over the past week, the stock is only offering a partially franked dividend yield of 4.6% for the year ahead.
Although the yields on offer from these two companies are still well above term deposit rates, investors need to understand that these stocks will become relatively less attractive and investors will require a higher yield to compensate for the higher risk involved with equities.
Another clear example of this is Telstra Corporation Ltd (ASX: TLS). Income-hungry investors piled into the stock over the last five years which resulted in a doubling of the share price. Since August, however, the share price has fallen by more than 20% as investors look for companies with better growth prospects.
By no means do I think Sydney Airport, Transurban or Telstra are poor quality stocks – far from it. These are some of the best quality infrastructure stocks on the ASX with great long term potential, but investors need to be weary of the impact that rising bonds yields can have on defensive, high yielding stocks.
Therefore, it would seem appropriate for investors to remain patient until the full effect of rising bond yields is known before taking a large position in these stocks.
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Motley Fool contributor Christopher Georges has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.