Rising US bond yields are important for the Australian share market because the US Treasury market is effectively the benchmark for global interest rates. When the yield investors can earn from a relatively safe US government bond rises, it changes the return investors demand from almost every other asset, including Australian shares. The effect on the ASX is therefore not simply that “US rates go up and Australian shares go down”. There are several different channels working at the same time, and some are negative for the ASX while others can actually be positive.

Why rising US bond yields matter to Australian shares

To understand the effect on the ASX, it helps to start with the relationship between bond yields and share valuations. When an investor buys a share, they are effectively buying a claim on the company’s future profits and cash flows. Those future profits have to be valued in today’s dollars. The interest rate or yield used to make that calculation is sometimes called the discount rate.

When interest rates are very low, future profits can be worth quite a lot today. When interest rates rise, those same future profits are worth less in today’s dollars.

Imagine two investments. A US government bond might offer a 2% return, while an investor expects an Australian company to provide a 7% annual return over the long term. The investor is being compensated reasonably well for taking the additional risk of owning the shares.

Now imagine the government bond yield rises to 5%. The investor can suddenly earn 5% from a relatively low-risk asset. The Australian company might still be expected to return 7%, but the investor is only receiving an additional 2 percentage points for taking considerably more risk.

That can make the share price less attractive.

This is one of the fundamental reasons rising bond yields tend to put pressure on share valuations. The required return on shares rises, and investors become less willing to pay extremely high prices for future earnings.

The effect is particularly strong on expensive growth companies

Not every company on the ASX is affected equally.

Consider a mature company that is generating $10 of profit today and is expected to generate $11 next year. Most of its value is based on profits that are relatively close to the present.

Now consider a growth company that makes very little profit today but is expected to generate enormous profits ten or fifteen years into the future. A large part of that company’s valuation depends on those distant future profits.

When the discount rate rises, the value of those distant profits falls more dramatically.

This is why rising bond yields can be particularly painful for technology, healthcare, speculative growth and other companies trading on high price-to-earnings multiples.

The US market is particularly sensitive to this because it has a huge weighting toward technology companies. The ASX has less exposure to those companies, which is one reason the Australian market can sometimes behave differently from the S&P 500 or Nasdaq when bond yields rise.

Rising US yields can push Australian bond yields higher

Another important mechanism is the connection between global bond markets.

Australian government bond yields don’t operate independently from US Treasury yields. International investors compare the returns available in different countries, and movements in major global bond markets can influence Australian yields.

The Reserve Bank of Australia has already noted that Australian long-term government bond yields have risen to around their highest levels since 2011, alongside increases in global bond yields. The RBA has also highlighted that global financial conditions can tighten when government bond yields rise.

The process can therefore look like this:

US Treasury yields rise → global bond yields rise → Australian bond yields rise → Australian borrowing costs rise → pressure on Australian companies and households.

This is important because Australian companies don’t have to borrow directly from the US for higher US yields to matter.

Higher bond yields increase the cost of borrowing

Suppose an Australian company has $1 billion of debt.

If it previously paid 4% interest, its annual interest bill would be approximately $40 million.

If refinancing costs eventually rise to 6%, the interest bill becomes approximately $60 million.

That’s an additional $20 million a year going toward interest rather than profits, investment or dividends.

For a company with very little debt, this isn’t a huge issue. But for a heavily indebted company, it can have a substantial effect on earnings.

This is why rising yields can be particularly problematic for companies that need to refinance large amounts of debt.

The same principle applies to property companies, infrastructure companies and REITs, which can be particularly sensitive to financing costs.

Banks are much more complicated

The effect on Australian banks is not necessarily negative.

In fact, higher interest rates can initially help banks because banks earn interest from their loans and pay interest on deposits and other sources of funding. The difference between what they earn and what they pay is an important part of bank profitability.

So if interest rates rise, banks can potentially benefit from higher interest income and margins.

However, there is a limit. If rates stay high for too long, households and businesses begin to feel the pressure.Someone with a large mortgage who suddenly has to pay thousands of dollars more in annual interest has less money available for restaurants, holidays, cars, clothing and other discretionary spending.

Eventually this can affect the broader economy.

It can also affect the banks themselves because weaker economic conditions can lead to slower credit growth and, potentially, more borrowers experiencing financial stress.So for the banks, rising rates can initially be positive but eventually become a problem if they weaken the economy sufficiently.

This is one reason you shouldn’t automatically assume that rising bond yields are good for Australian banks.

Commodity prices can protect the ASX

This is where Australia is different from many other developed markets. Australia is a major commodity exporter, so commodity prices have an enormous influence on the profitability of some of Australia’s largest companies. If iron ore, copper, gold, oil or other commodities are performing strongly, that can provide support for the ASX even when global bond yields are rising.For example, if BHP’s commodity prices are strong enough to substantially increase its earnings, investors may continue buying the company even though the general valuation environment is becoming less favourable. This creates an interesting situation. US bond yields can be rising, which is negative for valuations, while commodity prices are also rising, which is positive for the earnings of Australian resource companies. The two forces can offset one another.

Gold is another interesting case

Gold is unusual because it doesn’t pay interest.Normally, higher bond yields make gold less attractive because investors can earn more income from bonds.However, gold can perform strongly when investors are worried about inflation, geopolitical instability, government debt or financial uncertainty. So if US yields are rising because investors are worried about the US government’s fiscal position or geopolitical tensions, gold can sometimes rise at the same time as bond yields.That matters to the ASX because Australia has a substantial gold-mining industry.Therefore, even within the resources sector, the effect isn’t uniform.

Lauren Hua is a private client adviser at Fairmont Equities.

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