Bond yields are marching higher again with the US 10-year government bond (called Treasuries) adding to last night’s gain. Investors should get used to the prospect of higher bond yields.
The trend is fuelled by the prospect of interest rates rises around the world and that is acting as a drag on stocks, particularly those trading at a premium to the market as they have to contend with the rising cost of debt and stretched valuations.
This is why equity investors should be eyeing the increase in the US 10-year Treasury yield, which rose to 2.9% last night and inched up to 2.92% during the Asian trading session today.
Higher government bond yields also reduce stock valuations because analysts use the 10-year government bond as the risk-free rate to benchmark stocks. The higher the benchmark, the bigger the valuation discount analysts use in calculating their price targets.
This factor is contributing to the debate over buying the dip with volatility rocking the S&P/ASX 200 (Index:^AXJO) (ASX:XJO).
Most experts, including myself, continue to see upside for our market in the second half of 2018 as economic growth picks up pace to support corporate earnings. But consensus is more divided over expensive growth stocks that are trading at a premium.
Credit Suisse is shedding some light on this debate. The broker is forecasting further increases in bond yields as investor risk appetite returns and is tipping the US 10-year to hit 3.2% in 12 months given the US Federal Reserve’s interest rate tightening bias and a blowout in US government debt to fund US President Donald Trump’s expensive corporate tax cuts.
The world tends to follow the US Treasury market and ours is no exception. The Australian 10-year government bond yield is expected to jump to 3.1% from around 2.7%, according to Credit Suisse who is calling the run-up in bond yields a “Bondcano”.
This is one reason why ASX stocks with sizable debt burdens that are on high price-earnings (P/E) multiples have been falling behind, although this isn’t the case for a handful of growth stocks, notes the broker.
What’s interesting is that these Bondcano survivors share a few common traits. For one, they share the ability to be internally financed, if required.
“Their balance sheets are unquestionably strong, profits margins are enormous, capex requirements are generally puny as are their payout ratios,” said the broker.
Using these characteristics as a filter, Credit Suisse has picked three high P/E stocks that will rise above the Bondcano eruption. The stocks are online real estate website REA Group Limited (ASX: REA), sleep disorder treatment device maker RESMED/IDR UNRESTR (ASX: RMD) – more commonly called ResMed – and online travel booking site Webjet Limited (ASX: WEB).
On the flipside, high flying stocks that screened poorly on these measures include medical facilities operator Sonic Healthcare Limited (ASX: SHL), port and logistics operator Qube Holdings Ltd (ASX: QUB) and gas pipeline infrastructure owner APA Group (ASX: APA).
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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has recommended REA Group Limited, ResMed Inc., and Webjet Ltd. 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 Scott Phillips.