Watching the stock market crash is never pleasant. And US investors are certainly feeling this pain over the last week. This appears to have been triggered by rising bond yields. But what does that have to do with stocks? And where can I invest to protect my portfolio? Let’s explore.

What’s behind the stock market crash

Investors have been worried that the Federal Reserve (The reserve bank in the US) would taper its emergency bond-buying stimulus. This is more commonly known as quantitative easing and helps boost economic activity as more money becomes available. In 2020, the Federal Reserve raised its bond-buying escapades to $120bn per month. Given the US economy has been recovering relatively quickly from the effects of the pandemic, I think it’s fair to say the plan worked.

Today, the vaccine rollout is making headway. And so, the pandemic is slowly coming to an end. As a result, the Federal Reserve announced it would reduce its bond-buying activities from mid-2022 onwards. So naturally, bond investors started panicking and began closing their positions. To make matters worse, fears of prolonged inflation from supply chain bottlenecks also have spooked the investing community.

As a consequence, the 10-year treasury yield spiked up to as high as 1.56% this week. In other words, the cost of debt is going up for both individuals and businesses. But why would that cause a stock market crash?

The link between bonds and stocks

As a reminder, bonds are simply a securitised form of debt. Companies can issue them to raise capital for expansion and reinvestment. But it’s not free. Debt carries interest fees which a company has to pay usually on a monthly basis through bond coupons. Therefore, if the treasury yield is going up, so is the interest on corporate debt. And in turn, with more profits gobbled up by interest payments, profit margins are due to suffer.

This is why the treasury yield is taken into account when performing corporate valuation. A higher yield leads to a higher cost of debt, which, in turn, results in a higher cost of capital. It even impacts the cost of raising money through equity since investors will expect higher returns on their capital. Don’t forget the treasury yield is often seen as the risk-free rate of return.

The higher the cost of capital, the bigger the discount rate is used in discounted cash flow models. And that subsequently leads to lower valuation for companies. This is what caused the stock market to crash this week. Even a tiny percentage change in the discount rate can have a drastic impact on stock prices. And for the shares trading at a high price already, this impact is only amplified. That’s why tech stocks have suffered the most this week, despite most not having any debt on their balance sheets.

It’s also worth noting another likely contributor to the crashing stock market is the switching effect. As yields rise, bonds become more attractive, enticing income investors to switch from dividends in the equities market to coupons in the bond market.

Where should I invest to protect my portfolio?

Here at The Money Cog, we always focus on the long-term. With that in mind, these minor adjustments in bond yields don’t matter all that much. At least, not to us. While it’s not fun watching the stock market crash, the impact of slightly higher bond yields won’t impact most businesses. At least, not the healthy ones.

There is one industry that is set to benefit from this shift. And that’s the banking sector. Most banks make their money from issuing loans to individuals and businesses. So if interest rates start climbing, the profit margins for these financial institutions are likely to rise in parallel. In fact, this is why bank stocks haven’t been the best performers over the last decade since interest rates have been kept exceptionally low.

Having said that, fluctuating interest rates are just another part of the economic system. In the end, even if inflation rises and interest rates continue to climb, strong, high-quality businesses will be able to adapt and continue delivering value and wealth to shareholders. That’s what we’re searching for in our Premium service.