Treasury bonds are crashing.

The iShares 20+ Year Treasury Bond Fund (TLT) – which is designed to track the action in T-bonds with 20 years or more to go until maturity – is down almost 5% so far this month. That’s a huge decline for a fund that invests in government-guaranteed bonds.

But you may not have noticed – what with the action in the “pot stocks,” the trade war headlines, the Supreme Court soap opera, and the broad stock market approaching new all-time highs. A modest rise in interest rates may not be enough to capture most investors’ attention.

But it should.

You see, at a certain point, rising interest rates are bad for stock prices.

Higher interest rates eat into the profit margins for debt-heavy companies. Companies that have to re-finance large amounts of debt do so today at higher rates than at just about any time in the past four years.

Higher interest rates also make companies less likely to borrow money to fund stock repurchase programs. A corporate CFO looks like a genius if they can borrow money for 2% and then use that borrowed money to buy back shares that are paying 3% dividends.

The buyback helps support the price of the stock. It lowers the share count – which increases earnings-per-share growth. It reduces a costly dividend distribution. And the interest on the borrowed money is tax-deductible.

All of those benefits go away if interest rates rise. The genius CFO now looks like a fool if they borrow money at 4% to fund the same sort of buyback program that was so smart a few months ago.

But the biggest stock-market drawback to higher interest rates is that it creates competition for investors’ savings.

For most of the past decade, investors had no other alternative for their savings than to invest in stocks. Bank accounts paid nothing. Treasury securities paid almost nothing. The stock market was your only choice.

Now though, for the first time in 10 years, the yield on the 10-year Treasury note is significantly higher than the yield on the S&P 500. The 10-year note yield popped to 3.08% yesterday. Meanwhile the S&P 500 yields just 1.9%.

And, if the Federal Reserve Board hikes their Fed funds target rate to between 2% and 2.25% next week, as expected, then Treasury bills will yield more than the S&P 500. That’s likely to make “cash” relatively more attractive, and stocks will be relatively less attractive.

The financial media doesn’t seem too concerned about higher rates this week. They’ve largely ignored the steep selloff in Treasury Bonds.

But investors should start paying attention. Pretty soon, it’s going to be hard to argue in favor of paying 19 times earnings to invest in the stock market when there’s a respectable, lower-risk alternative.

Best regards and good trading,

Jeff Clark

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