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.