Those companies that offer low stable growth, steady dividends and low volatility have been used by investors and fund managers as ‘bond proxies’. Low interest rate environment companies, typically in the utilities, consumer staple, pharmaceuticals and property sectors, were added to portfolios to replace near zero yielding bonds. Over the past 5 years these sectors have enjoyed strong gains and valuations now look stretched; if you introduce a rate hike and slower growth these sectors could be hit particularly hard. The P/E ratios of bond proxies are a real source of concern. Since the financial crisis and the subsequent extended period of record low interest rates investors piled into dividend paying stocks in a desperate quest to attain yielding assets. The FTSE 100 Utility sector now has a higher average forward PE than the Life Insurance and Banking sectors; this is fine if growth remains steady and interest rates low, however as anyone who follows financial news knows, rates are not going to remain low forever. In fact, rates are looking likely to rise this year, particularly in the US. A rate rise and the impact on the stock market is a well-researched topic – generally the initial aftermath of a rate hike is negative for equities. The kneejerk sell off is usually followed by a rally as the first rate hike is almost always the result of a strengthening economy. which in turn supports corporate earnings. From an investors point of view, it is always important to be mindful that certain sectors underperform and outperform given the economic and political backdrop. The problem going forward for bond proxies boils down to risk; in particular, the risk investors take to obtain a yield. In a low interest environment with bond yields below 2%, investors are forced towards risky assets such as equities that may yield upwards of 3%. This paradigm has been observed since the 2007-2008 financial crisis and bond proxy sectors have gained substantially. However, the US 10 year treasury yield has been rising for a number of months after hitting lows in early 2015 and is trending towards yields in excess of 3%. The same is true of UK 10 year gilts, albeit with a slightly lower yield. If yields continue to rise, investors are given the luxury of asking themselves; why am I risking my money in relative risky companies when I can give it to the US or UK government and receive the same yield? Although the prospect of capital appreciation is limited with bonds, so is the risk of a capital loss. The same cannot be said of companies like Unilever, Centrica and AstraZeneca. Stocks are notoriously volatile when compared to bonds, and volatility in bond proxy stocks is only likely to increase as bonds begin to become a viable option for investors as they dispose of their proxy stocks. There may also be a snowball effect as the share prices of bond proxies drop, further unnerving an increasing amount of investors who look at the high valuation and question their medium term prospects. As previously mentioned, classic bond proxy sectors are trading at higher valuations than those sectors that typically benefit from rising rates, such as the financial sector. In addition, banks tend to perform better when interest rates rise; a rotation out of bond proxies into financial stocks will also add to the potential downside pressure. There are also other sectors than tend to rise with interest rates, but this is more down to the underlying improvements in economic activity as opposed to direct benefits of higher interest rates. The timing of any change to the current investment environment is inextricably linked to the Federal Reserve and Bank of England and their judgement of when rates should rise. As both institutions have said, a rate hike is dependent on economic indicators; ultimately it is likely the share prices of bond proxies will be negatively correlated to economic strength for a period in the next 12 months.

As expectations of an interest rate hike by the Federal Reserve continue to rise, Investor Magazine examines the approaches of Alan Greenspan, arguably the most influential Chair of the Federal Reserve, and the current Chairman Janet Yellen. The Fed are legally obligated to pursue two potentially conflicting targets: “stable prices” and “maximum employment.” Those who focus primarily on squashing inflation are known as hawks, and those that give a higher weight to boosting employment and G.D.P. growth are known as doves. Alan Greenspan is perhaps one of the most well-known Chairmen of the Board of Governors of the Fed Reserve, serving an unprecedented 5 terms as Chairman between 1987 – 2006 during Reagan, Clinton and Bush’s presidencies. Traditionally seen as a hawk; Greenspan was criticized for strongly pursuing inflation when instead he might have turned his considerable power towards attaining full employment or economic growth. In fact, Greenspan broke away from his hawk stance in 2000, when the dotcoms burned out, and again in 2001, after the World Trade Center was attacked. Perhaps a better view is that Greenspan was hawkish to begin with then became dovish as his reign went on; his dovish approach to Federal policy lasted well into the 1990s. The past two chairmen of the Fed, Alan Greenspan and Ben Bernanke, both fit the description of doves disguised as hawks. Aligned with conservative Republican Administrations, they both entered the job talking about the virtues of price stability and yet, for much of their time as Chair, they both pursued relaxed money policies, which consisted, in part, of keeping interest rates at very low levels and pumping money into the financial markets. Janet Yellen, the current Chairman of the Federal Reserve, became vice-chair in 2010 and chair in 2014. In comparison to Alan Greenspan, upon ascending to her position she was seen as a dove by most on Wall Street; when President Obama nominated her last year to head the Fed, bond king Bill Gross told Bloomberg TV, “She’s a dove with a capital D” . Her sympathetic attitude to unemployment led to the suggestions that she would be taking a more dovish approach; in a speech back in February, she noted that long-term unemployment, which has risen sharply since 2008, is “devastating to workers and their families …. The toll is simply terrible on the mental and physical health of workers, on their marriages, and on their children.” However, it has more recently been argued that she is more of a “hawk in a dove’s clothing” It is now becoming clear that Yellen may not be a true dove—that is, that she will consistently put fighting unemployment above keeping a lid on inflation: “I’ve said repeatedly, and I want to say again, that if events surprise us, and we’re moving more quickly toward our objectives … we have the flexibility to move” Yellen pushed hard for rate rises in 1996 to choke inflation, and has made it clear that she may do so again when the moment comes. The element of flexibility is arguable her strongest quality – she is someone who is willing to change their mind when the facts change. Strong jobs and spending data since the beginning of June are not expected to be enough to bring about a rate hike at the US central bank meeting this week, That leaves only four policy meetings remaining after this for a move: July, September, October and December. by Miranda Wadham