Except for a few days in 2005, the spread between corporate and treasury bond yields hasn’t been as low as it is now since 1997. These low credit spreads are the backdrop for the pivotal role of treasury yields in the US contest between growth and value stocks.
Value stocks are often defined as cheap based on fundamentals such as book value or earnings. I use Free Cash Flow (FCF) here because it avoids potential accounting distortions and is arguably a clearer indication of a company’s fundamental value. Since cash flow duration is shorter for value companies than growth companies, FCF yield (Free Cash Flow per share divided by current share price) should give a clearer picture of the potential impact of interest rates on value stocks. Specifically, I use a long-short portfolio of stocks from the top 500 market cap US stocks, long the top FCF yield stocks and short the lowest in each sector (i.e., sector neutral), rebalanced monthly.
The chart's four plots depict the role of the treasury yield and credit spreads on the value trajectory.
Focus first on the plots in the top row. The orange line in both plots shows the return to FCF yield. The blue lines in both show the yield on a constant maturity 10-year treasury bond. The plot on the right covers the past seven years - since March 2016. The plot on the left shows the seven years before March 2016. The critical point is the very different relationship between interest rates and the return to FCF yield in the right and left plots.
Since early March 2016 (right top plot), the return to FCF yield has covaried with the direction of interest rates. Deviations from their shared path are temporary. Before 2016 and after the Great Financial Crisis (left top plot), there was no consistent connection between interest rates and the success of FCF yield. Why the change?
Now, focus on the plots in the bottom row, which show the yield spread between BAA corporate bonds and 10-year treasuries. The time windows in each bottom plot are the same as the top plots. The dashed red line in each bottom plot is the average credit spread for that period. On average, the spreads were 80 bp higher before 2016 than after.
When credit spreads are high, investors demand a higher yield for taking on the additional risk associated with corporate bonds than relatively risk-free treasury bonds. This focus on company credit risk makes the economy and treasury yields less relevant than when credit spreads are low and investors are less worried about corporate default. Since credit risk is currently low, the direction of treasury yields is significant because of the differing cash flow durations associated with value and growth stocks. Rising treasury yields should favor value; falling yields should favor growth – like the recent seven years.
