Wall Street Week Ahead: Surging Treasury yields upend stock market’s ‘bond proxies’

NEW YORK: Soaring Treasury yields have stunned the US equity market in recent weeks, with some of the worst fallout hitting a group of stocks expected to have bond-like qualities.

The S&P 500 is down about 4% since the Federal Reserve’s hawkish interest rate projections last month sent US yields to 16-year peaks and accelerated an equities pullback from highs reached in late July.

While rising yields are generally seen as unfavorable to growth stocks, some of the steepest losses have been concentrated in more staid sectors such as utilities and consumer staples.

Such areas are often referred to as “bond proxies” for their strong, stable dividends, which over the past decade have usually exceeded Treasury yields.

Those hefty payouts, as well as businesses perceived to be more durable during a rocky economy, led many investors to view them as a safe harbor when markets grew turbulent.

But surging bond yields have dulled the appeal of bond proxies. Investors can now earn higher yields on government debt seen as virtually risk free if held to term.

The yield on a six-month Treasury now stands at around 5.6%, while the utilities sector was yielding 4% and staples yielded 3%, according to LSEG data.

As a result, shares of bond proxies have taken an outsize hit in recent weeks. The S&P 500 utilities sector has tumbled 13% since last month’s Fed meeting. Staples has dropped about 8% in that time, with investors also assessing the impact on consumer companies from a new class of weight-loss drugs.

Other areas known for their dividend appeal have also suffered, with real estate off 8% since the Fed’s meeting, and telecom stocks AT&T and Verizon dropping 7% and 8%, respectively.

Investors have scrambled to recalibrate their portfolios following the Fed’s outlook suggesting rates will stay higher for longer, which has also strengthened the dollar and sent gold sliding.

The underperformance of bond proxies shows “the market is finally buying that we are in a completely different interest rate regime,” said Irene Tunkel, chief US equity strategist at BCA Research.

Bond proxies were underperforming after Friday’s US employment report showed jobs growth surging above expectations and the yield on the benchmark 10-year Treasury shot up over 4.8%. Next Thursday’s consumer price index report will be critical for investors assessing whether the Fed will seek to raise rates further to fight inflation.

Next week also kicks off third-quarter earnings results for US companies, with several major banks reporting. The earnings season could determine the near-term path for stocks, with the S&P 500 still logging a 10% gain for the year even after its pullback.

The utilities sector’s steep slide has put the group in particular investor focus. Problems have been compounded by the share plunge for the sector’s biggest company by market value, Nextera Energy. Nextera shares have tumbled 27% since the end of last month, when a subsidiary, Nextera Energy Partners, cut its growth outlook.

Earnings may not provide much relief for utilities. While the sector is expected to see stronger growth than the overall S&P 500 in the third and fourth quarters, its projected 8.6% increase in 2024 lags the expected 12% rise for the overall S&P 500, according to LSEG IBES.

Weakness in utilities shares spells opportunity for some investors. The Philadelphia SE Utilities index indicates the group trading at its lowest relative valuation to the S&P 500 since 2010, excluding the initial coronavirus period in 2020, analysts at KeyBanc Capital Markets said in a note this week, adding “we now view the sector overall as attractively valued.”

Retail investors poured $32 million into utilities shares, far larger than any other prior five-day stretch, according to weekly data from VandaTrack, which follows retail activity.

Whether the stocks are worth scooping up could depend on an investor’s outlook for interest rates, said James Ragan, director of wealth management research at D.A. Davidson.

“If you think that the 10-year yield is going to go to 5% and keep running a bit, then I don’t think the utilities are going to do very well,” Ragan said.