Yield wars: Bonds vs equities

Ben Willis, investment manager and head of research at Whitechurch Securities, does not believe the ‘great rotation’ will be a sudden asset allocation move, instead expecting a continuation of a gradual movement towards equities that has already been witnessed over the past year.

“With the attractiveness of both government bond and corporate bond debt waning, it makes sense that they will gradually allocate more to the income producing asset that sits on the next step in terms or risk – namely, defensive, large cap, dividend paying companies that have solid track records of generating dependable profits and paying dividends to shareholders,” he explains.

“These kinds of stocks have been acting as bond proxies for the last year or so and have been sought after.”

Of course, investors dissatisfied with returns from fund weighted to government bonds could simply go corporate.

Bond funds that focus on corporate bonds have been an investor favourite in the past year, as the hunt for income took hold in an environment of low interest rates and increased volatility in the equity market. Returns from these funds in 2012 were generally strong.

However, Ignis head of UK equities Graham Ashby argues that the outperformance of corporate bonds in 2012 was the exception rather than the rule.

Citing the Barclays Capital Equity Gilt Study 2013, he says: “The real return from UK equities after inflation has been much higher than corporate bonds in the past 10 years.

“This long-term outperformance of UK equities relative to corporate bonds is to be expected, as equities are further down the capital structure and therefore typically offer investors a higher return for taking on higher risk.

“In addition, equities have the added benefit of offering the potential for dividend growth, while most corporate bonds offer investors a fixed coupon.”

Bond options

While the broad statistical evidence appears to be pointing towards the superiority of equities at present, investors must take account of a number of considerations before simply moving their income allocation into equities.

Adam Avigdori, manager of the BlackRock UK Income fund, agrees that in an environment of rising bond yields, investors should consider the importance of future dividend growth.

“If you already have a high dividend yield and it doesn’t grow, your shares will be far more susceptible to profit-taking in the event of rising yields. If companies can convince investors that they can grow dividends faster than inflation, gilts or corporate bonds become relatively less attractive,” he says.

In spite of corporate bond yields – both investment grade and high yield – being significantly lower as a result of price rises and narrow spreads, there are selective opportunities for those willing to hunt for them.

Mr Willis says: “Investment grade bonds still offer some value (selectively) as they are most sensitive to interest rate risk, which doesn’t appear an issue in the near term as interest rates look highly likely to remain at emergency levels.

“Within high yield markets, once again there are opportunities but it still pays to be selective as there is the higher risk of default and they are more correlated to equity markets than to interest rate sensitivity.”

Chris Higham, corporate bond fund manager at Aviva Investors, for example, claims that the result of companies spending the past four years paying down debt is historically low default levels among even ostensibly riskier high yield issuances.

“One of the key questions we have heard from clients this year has been around market liquidity. The amount of money going into credit has created concerns that at some stage this money may need to come out of the market.

“However, it is often overlooked that equity market volumes have declined in recent years and corporate bond market liquidity in terms of turnover has actually increased. So while it should be a consideration, I am confident that there is sufficient liquidity to enable us to provide attractive returns to investors,” Mr Higham explains.

QE questions

While concerns surrounding liquidity in the fixed income sector remain, so too is the concern about the US Federal Reserve putting the brakes on its quantitative easing measures. This is likely to place additional pressure on bonds.

Ian Spreadbury, senior portfolio manager at Fidelity Investments, points out: “Quantitative easing keeps the economy artificially afloat and allows inefficient companies and public spending to survive where market dynamics would have forced them to shut down or restructure under normal circumstances.

“However, you can only play the cards you are dealt and given the likely steep upward trajectory in yields in the event of QE tapering, I do not see an end to QE in the short term.

He adds: “Only growth can truly allow for a fairly painless unwinding of QE and there is little prospect for significant growth in the medium term.”

David Zahn, fixed income manager at Franklin Templeton, echoes this view and suggests that while ‘QE tapering’ talk has rattled the global markets, investors shouldn’t panic.

“The Fed has made it clear they are focused on unemployment as a key factor, and at the moment the unemployment rate hasn’t gone down to the place where they would likely be doing something.

“So I think we will still have easy policy coming out of the US for some time. It may be QE or it may be low rates for a while, but I don’t see tight policy coming out of the Fed. Hopefully if they do that, that means growth is getting better.”

Risk vs return

Focusing on the risks in relation to bonds is important, as for investors on the hunt for income the question is not whether they should be looking at bonds over equities or vice versa, but simply one of risk.

Just how much risk is an investor are willing to tolerate to get the return – both in terms of income and capital growth – from an investment? Equities have very clear risks and the volatility of equity funds can be severe, but the risks in the current climate related to bonds funds must be properly understood.

Many high yield bond offerings are not as risky as they once were due to deleveraging and could provide a strong return option, while liquidity across bond markets has generally increased. But bonds do carry their own risk considerations in the current climate, especially with lower yields reducing the ‘return’ portion of the value equation.