According to a report from Zhitong Finance APP, strategists at Bank of America believe that if the 10-year US Treasury yield approaches its year-end target of 5%, small-cap stocks could see a rebound. However, due to persistently high leverage and refinancing risks, the bank still prefers mid-cap stocks.
Meanwhile, the benchmark 10-year US Treasury yield briefly surged to 5.36% on Wednesday, hitting a 24-year high just hours before the US government auctioned debt of that maturity.
BofA: Small-Cap Risks Intensify, Mid-Caps More Stable
Bank of America strategist Jill Carey Hall wrote in a note to clients that historically, when the 10-year US Treasury yield exceeds 6%, the forward price-to-earnings ratio of the Russell 2000 Index declines. However, when yields are between 6% and 8%, earnings per share (EPS) revisions are above average, indicating that past valuation compression coincided with stronger earnings growth. Therefore, within the 6% to 7% yield range, average returns for small-cap stocks have historically not been weak.
Today, the price-to-earnings ratio of the Russell 2000 Index is already below the historical average levels seen in previous 5%-6% and 6%-7% interest rate environments. Although valuations have been compressed, structural changes have made small-cap stocks more vulnerable to high interest rates than in previous cycles.
The negative correlation between small-cap price-to-earnings ratios and the 10-year US Treasury yield has reached historically high levels, driven by high corporate leverage and a record proportion of unprofitable companies in the Russell 2000 Index.
BofA points out that high interest rates—partly driven by Federal Reserve rate hike expectations—pose a direct challenge, as about half of small-cap debt is short-term or floating-rate debt, and the share of long-term debt maturing within the next five years is increasing.
BofA expects the 10-year US Treasury yield to be 5.0% by year-end. If yields stabilize, this would provide an opportunity for a small-cap rebound. However, the bank warns that yields could remain elevated or rise further before economic data weakens or financial conditions tighten.
Therefore, BofA continues to recommend overweighting mid-cap stocks over small-cap stocks, citing mid-caps' lower interest rate risk and similar earnings recovery prospects in the second half of the year compared to small-caps.
Which Mid-Cap Stocks Are Worth Watching?
Given BofA's preference for mid-cap stocks, the following are top-ranked US mid-cap stocks screened by the Seeking Alpha quantitative rating system, covering sectors such as energy, semiconductors, biotechnology, electronics manufacturing, and hotel REITs, for investors' reference:
Eaton Vance Municipal Bond Fund (EIM) is among the top-ranked US mid-cap stocks identified by the Seeking Alpha quantitative rating system.
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