Realty Income Corp (O): Why Does the Market Love U.S. Treasuries?

The 10-year Treasury is one of the most important measures on Wall Street. The yield on the 10-year note is seen as the alternative to stocks: a longer-term investment with a risk-free return.

Stocks generally move inversely to the 10-year yield, making it a key indicator for future market movements. When the 10-year yield is over 2%, it’s time to rethink a stock portfolio. Risk-free yields are at a 52 week high of 2.22%, so it’s time to start moving out of defensive dividend and income stocks.

Why treasury yields matter

The 10-year U.S. Treasury is the most important metric on Wall Street. Institutional investors use the Treasury yield to forecast inflation expectations, price corporate debt issues, and value future corporate earnings.

Remember, when you and I want to move to cash, we can move funds to our bank account. When hedge funds, banks, and institutional investors move to cash, they move to U.S. Treasuries.

The U.S. Treasury yield is especially important for yield-driven investments because it is a safe alternative to risk assets. When investors want yield but limited market risk, they turn to the government’s debt. Government debt is “risk-free” in the sense that the government can always print more money.

Stocks most affected by risk-free yields

Treasury yields deliver the largest impact on “safer,” above-average dividend paying companies. This list includes real estate investment trusts (REITS) and utilities.

When the 10-year Treasury hits 2%, investor cash begins to flow from stocks, especially dividend-paying equities. That sparks a decline in stock prices.

So what’s up with government bonds? The 10-year risk-free rate struck a low of 1.61% on May 1, 2013. Yields rose rapidly to 2% by May 21. Today, yields rest at 2.22%.

10 Year Treasury Rate data by YCharts

On May 22, REITs took a tumble. Realty Income Corp (NYSE:O), which brands itself as “The Monthly Dividend Company,” fell from $55 per share to a low of $43 per share as risk-free yields surged higher.

O data by YCharts

Realty Income Corp (NYSE:O)’s monthly dividend policy plays into the “clientele effect,” attracting investors who care about income from their investments. Rising risk-free rates can lure income investors away from REITs.

Higher rates also undermine its business model, which relies on inexpensive financing for its portfolio of leased property. Rising rates are a double whammy for REIT investors. Falling rates, however, can drive REITs higher and higher.

Realty Income Corp (NYSE:O) currently yields 4.3%, which is only a modest premium to the 10-year risk-free rate of 2.17%, given the riskiness of commercial real estate and the volatility in the stock market.