Bond proxies – should we be worried?

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Mitchell Fraser-Jones 29 May 2015 Est. reading: 5 min read

Strictly speaking, it’s not ‘our asset class’ but events in the bond market in recent weeks have caused some consternation for equity investors. In particular, we have recently been asked whether we are worried about the impact of a bond market sell-off on ‘bond proxies’, or equities with bond-like characteristics.

We always pay close attention to the behaviour of bond markets. The fixed interest asset class is much more interested in reading the pulse of the real economy and tends to be much better and faster at pricing in macroeconomic developments than the equity asset class. Many equity investors pay no heed to macroeconomics, claiming it to be irrelevant (read too difficult) to the job of picking stocks. We completely disagree with this notion – all companies operate in the real economy and are therefore exposed (some more than others) to the slings and arrows of the macroeconomy. Having a comprehensive, fundamental understanding of the long-term macro-economic outlook is therefore a critical part of our approach, informing our assumptions and judgements on all investment opportunities. Bond market behaviour can be instructive in this pursuit.

Nevertheless, the bond market isn’t always right and does sometimes send false signals. The reasons behind the recent bond market sell-off, for instance, have been hard to fathom. Some have suggested the European sovereign bond market’s recent correction (the yield on 10 year German Bunds went from 0.08% to 0.72% in less than a month) was prompted by underlying improvements in the eurozone economy. Others have suggested that, as a result of a pickup in the oil price, it is indicative of diminishing fears of deflation or even a renewed bout of inflation in the western world. We think that these attempts at post-event rationalisation are somewhat wide of the mark. Instead, the bond market correction was, in our view, more a case of flow than fundamentals – European sovereign bonds and other related credit markets have been in huge demand as a popular way of ‘trading’ the arrival of European QE. This triggered a rally in which some markets became over-extended and, initially, the sell-off corrected that. The initial move probably alarmed some participants out of this crowded trade, which simply exacerbated the speed and scale of the correction.

In light of this, we do not think there will be a prolonged sell-off in bond markets – at least, not yet. Credit markets are in dangerous valuation territory where capital losses ultimately look inevitable in the long-term. In the meantime, however, with the demand for fixed interest securities remaining strong and economic fundamentals remaining weak, we believe bond yields could revisit their lows in the months ahead.

Another reason we do not fear a ‘bond proxy’ effect on the portfolio involves valuation. If equities with bond-like characteristics traded on the same valuation as bonds, there would be reason to worry. Arguably, some equities do and many others are over-valued in our view, but, importantly, not the ones that we have invested in. As far as income investing is concerned, we are attracted to investment opportunities where the starting dividend yield is attractive and where we are confident about the prospect of sustainable long-term dividend growth. Those two features provide fundamental security to the portfolio. If there was a continued correction in bond markets in the near-term, the portfolio could be affected by sentiment towards ‘bond proxies’ but, longer-term, there is still a fundamental valuation attraction to all of the stocks that we have invested in.

By way of example, BAE Systems paid dividends totalling 20.5p per share from its 2014 financial year profits. The dividend has been growing modestly in recent years, as the impact of defence spending cuts on both sides of the Atlantic has crimped the company’s operational performance. However, thanks to a strong forward order book, the nature of its long-term contracts and the strength of its relationship with key customers, we are confident that the dividend is well-placed to grow sustainably in the years ahead. At the current share price (521.5p at yesterday’s close), a 20.5p dividend equates to a historic yield of 3.9%.

This is a much more attractive income stream than that available on most sovereign bonds currently. Looking at 10 year maturities, Gilts yield 1.8% currently, US Treasuries 2.1% and German Bunds, even after the recent sell-off, yield just 0.5%. BAE’s dividend yield is more than double the yield on 10 year Gilts therefore, and with the prospect of long-term dividend growth, looks substantially more attractive, in our view. You have to look towards sovereigns such as Brazil, Turkey or Indonesia to find 10 year bond yields that are higher than BAE’s historic dividend yield.

Indeed, bizarrely, BAE’s dividend yield is even higher than the yield on its own corporate bonds! BAE raised $800m in September last year, by issuing a 10-year dollar-dominated bond with a 3.8% coupon. This bond currently offers a yield to maturity of 3.4%. Prior to the recent bond market sell-off, the yield was as low as 2.9%! This sort of valuation anomaly is not just confined to BAE Systems – it is widespread amongst the largest holdings in the equity income fund’s portfolio. In our view, it is indicative of both the over-valuation of bond markets currently and the under-valuation of select high-quality, dependable growth stocks.

How can it be that a fixed income stream is valued more highly than an income stream that is likely to grow over the long term? The aberration is evident in year one but, if BAE is able to grow its dividend at, say 5% per annum, the anomaly becomes even more profound over time. At this rate of growth, assuming a static share price, BAE shares will be yielding 6.1% by the time this particular corporate bond matures in 2024. It doesn’t make any sense! Bond and equity investors appear to be operating completely independently and nobody is joining the dots.

Ultimately, equities and bonds are quite similar beasts. All dividend-bearing equities can be considered to have ‘bond-like characteristics’ – they should be viewed as bonds with variable coupons and no predetermined maturity. This makes equities a less ‘certain’ proposition than bonds but, in the current valuation context, equity investors should be well-rewarded in the long term for embracing that uncertainty, particularly in businesses that can provide sustainable dividend growth going forward.

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