Real bond yields have been on a decline recently, and this trend shows no sign of stopping. With this in mind, it appears that technology and communications stocks are solid options for investors.
The real yield of a bond is determined by subtracting the expected annual rate of inflation from the bond’s simple yield. The higher the real yield, the greater the return in relation to inflation.
Currently, the simple yield on 10-year Treasury debt stands at around 4.61%. Based on data from the St. Louis Fed, the expected annual inflation rate over the next decade is approximately 2.34%.
By subtracting the expected inflation rate from the simple yield, we are left with a real yield of about 2.27%. This represents a decrease from the 2.5% figure observed earlier in October.
The decline in the real yield is primarily due to a decrease in the simple yield over the past few trading days, with inflation expectations remaining relatively stable. September’s consumer price index indicates an annual inflation rate of 3.7%, consistent with August’s reading.
Fortunately, the core CPI rate, which excludes volatile food and energy prices, has decreased since August. This has fostered optimism among investors that inflation will continue to decrease, particularly given the Federal Reserve’s commitment to maintaining high short-term interest rates in order to keep prices in check.
Examining historical trends further strengthens the argument for a lower real yield. Since the financial crisis of 2008-2009, the 10-year real yield has largely remained below 2%. Bond investors are typically content with a modest return above expected inflation if they are confident that inflation will not spike significantly.
Currently, buyers seem eager to push up the price of the 10-year note, leading to a decrease in its real yield. Dennis DeBusschere of 22V Research anticipates a possible decline in real yields during the fourth quarter.
Overall, the outlook for real bond yields suggests a continuation of their decline. This presents an opportunity for investors, particularly in the technology and communications sectors.
Embracing the Appeal of Tech Stocks
Fast-growing companies, especially in the tech sector, have been gaining significant popularity among investors. These stocks are valued based on the expectation that they will generate substantial profits in the future, similar to the returns from a 10-year note over time.
However, the allure of long-term government debt as a safer investment has diminished due to lower real yields. Consequently, investors are finding greater motivation to invest in tech shares, which are priced based on long-term cash flow forecasts. As a result, the valuations of tech stocks continue to rise.
Over the past decade, there has been a negative 33% correlation between real yields and tech stocks in the S&P 500, according to 22V Research. In simple terms, as real yields decrease, the value of tech stocks tends to increase.
This trend is only just beginning to gain traction. The Technology Select Sector SPDR exchange-traded fund, which tracks S&P 500 tech stocks, experienced a modest increase of nearly 5% since reaching a low point in early October. This upward movement aligns with the decline in 10-year real yields.
Similarly, communication services stocks in the S&P 500 have shown a negative 58% correlation with real yields. One contributing factor is that more than half of the market value in the S&P 500 Communications Service Sector index consists of stocks that are essentially technology companies—meta Platforms (META), Alphabet (GOOGL), and Netflix (NFLX)—despite being classified as communication entities.
Additionally, the telecom industry, including AT&T (T), Verizon (VZ), and T-Mobile (TMUS), holds a significant portion of the fund’s industry weighting. These telecom giants often experience a boost when real yields drop, as it makes their dividend yields—arguably a key reason investors buy these stocks—more appealing. Verizon and AT&T currently offer yields of approximately 8%.
Since hitting its lowest point in October, the S&P 500 Communications Services Sector Index has seen a growth of about 4%.
Considering these factors, it is worth exploring the potential of investing in these stock groups.