The sharpest rise in Canadian bond yields since the outset of the oil crash has made laggards of dividend stocks and bond proxies.
The recent upswing in long-term rates lifted the benchmark yield on five-year Government of Canada bonds over the 1.3-per-cent mark this week for the first time since late 2014, when energy prices were in free fall in the lead-up to a Bank of Canada rate cut.
Predictably, income-related stocks have not fared well in the rising-rate environment. As yields have increased in recent months, rate-sensitive sectors such as utilities, telecoms and real estate have all materially underperformed the rest of the Canadian market.
"With the market looking at more growth and more inflation, that's textbook performance," Bank of Montreal chief economist Doug Porter said.
If U.S. growth and inflation continue trending higher, so too should Canadian yields, keeping the pressure on income-related equities.
Globally, the rate environment started to turn in the middle of last year.
Growing concern about the unintended consequences of negative interest rates compelled European and Japanese bankers to step back from quantitative-easing programs. As they signaled less commitment to scooping up long-dated bonds, the negative pressure on yields began to ease, Ian de Verteuil, head of portfolio strategy for CIBC World Markets, said in a report.
Meanwhile, improving economic readings and inflationary pressures in the U.S. economy started to pick up last summer, and U.S. yields bottomed out.
"The election of Trump turbocharged this environment," Mr. de Verteuil said.
U.S. President Donald Trump's pro-growth agenda magnified economic and inflation expectations, and increased the likelihood that the U.S. Federal Reserve would continue to withdraw stimulus.
On Wednesday, the Fed stuck to that script in raising its target funds rate by 25 basis points – the third hike in the past 15 months.
Fixed-income markets went slightly off-script in reaction, however, possibly on the expectation that the Fed was going to signal more aggressive rate hikes to come. But Wednesday's decline in long-term yields still left the U.S. five-year benchmark at about 2 per cent, not too far off the six-year high set on Monday.
And as U.S. yields go, so go Canada's. The tight historical correlation between the two markets has held up since the Canadian five-year yield hit an all-time low of 0.49 per cent in February of last year.
That year-plus stretch has not been a particularly rewarding time for Canadian income investors.
Those sectors that tend to be most generous with dividends, such as utilities, telecoms and real estate, are also those typically most sensitive to rising interest rates. They are weakened relative to fixed-income alternatives in attracting investors on the hunt for yield.
Since early February, 2016, the S&P/TSX composite index has risen by 28 per cent. Over that time, the telecom sector is up by 6 per cent, real estate by 15 per cent and utilities by 16 per cent.
The key question for Canadian income investors is whether the rise in long-term interest rates is likely to continue.
"Though the move may be less robust, the direction of Canadian long rates will likely follow those in the U.S. – and that is higher," Mr. de Verteuil wrote. "This will continue to create a headwind for 'bond-like' equities."
The case for rates continuing to rise over the longer term is not a difficult one to make, Mr. Porter said.
He considers a good rule of thumb to be that the 10-year yield on government debt should be close to the growth rate of nominal GDP.
Even a very conservative estimate puts Canadian real GDP growth plus inflation at 3 per cent, while the benchmark 10-year yield sits at just 1.77 per cent, Mr. Porter said.
"Even if you're incredibly cautious on the long-term economic outlook, you still have got to believe yields have a way to go."
Tim Shufelt