Since the end of Q3 2020, there has been a marked rotation from ‘pandemic stocks’ (mainly tech) to ‘recovery stocks’ (industrials, financials, consumer discretionary, etc.). Many tech stocks – like Amazon, Facebook Netflix, Zoom – are flat-to-down while the broader market hits new all time highs.
While there might be some intuitive sense to this as return to normal approaches, many people are pointing to rising yields as the cause.
Why Rising Yields Impacts Some Stocks More Than Others
Many people understand that rising yields have a negative impact on the prices of bonds. A bond represents a series of cash flows in the future. The higher the discount rate (of which the risk free rate is a part) the lower the present value of those cash flows.
The sensitivity of a bond’s price to changes in yield is neatly wrapped up in a single data point called ‘duration’. Higher duration bonds have a greater sensitivity to changes in yields.
Duration can be sort of described as a weighted average of time to receive cash flows. The longer it takes to receive cash flows, on average, the higher the duration.
Therefore, a zero coupon bond will have a higher duration than a coupon-paying bond. All things equal, a 30 year bond will have a higher duration than a 10 year bond. And so on.
While many people understand how duration impacts bond prices, they forget that the same concept applies to stocks.
You can look at a stock like an infinite-term bond. In doing so, it becomes clear that a non-dividend paying stock (like most tech stocks) have a higher duration than more traditional dividend-paying stocks.
Going even further, because many tech companies don’t generate positive EBITDA or cash flow they trade on the expectation of a potential cash flow in the future. In comparison, most recovery stocks are tried and true, generating reliable cash flows quarter-after-quarter. So when considering the cash flows generated by the firm itself, a business that might generate cash sometime in the future clearly has a higher duration than a business generating cash today. For these reasons, most tech stocks have a higher duration than most traditional stocks, and are therefore more sensitive to rising yields.
Yields are a component of the cost of capital. A rising risk free rate raises the cost of capital for all businesses. While tech stocks operating on promises of future cash flows might do well when money is virtually free, they face rising challenges when capital becomes more scarce or expensive. In comparison, businesses that can fund capital investment via retained earnings and current assets (i.e. through realized earnings and cash on hand) and don’t have to tap into capital markets to stay afloat may start to outperform when yields start to rise.
With all that said, let’s be real. As a proportion of where they were last August, yields have risen a lot. But in absolute terms, yields are basically near the bottom of a 10 year range. The 10 year US Treasury yield is essentially where it was a week before the pandemic started.