Fixed Income  

Finding bond alternative requires shift in thinking

This article is part of
Hunt for Income - November 2015

The hunt for income has become more difficult with bond yields compressed to all-time lows and extremely inflated capital values that may collapse when interest rates rise.

Notwithstanding these facts, liquidity in secondary bond markets has been brought into question in many quarters, most recently by the governor of the Bank of England, Mark Carney, following his institution’s survey of 135 UK investment houses this summer.

Some would argue, however, that interest rates will remain near zero for a long while yet and should conceivably fall further due to the emerging markets slowdown and global slump in commodity prices feeding into a deflationary cycle.

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Indeed, this is a possibility, but if that happens, already compressed yields become even more squeezed and already swollen capital values become even more inflated and susceptible to collapse when interest rates do actually rise.

We have already experienced the decoupling of correlation between bond yields and interest rates, and bond values are fluctuating sharply based on ‘assumptions’ of when interest rates will rise rather than the actual event.

The combination of these factors makes investing in conventional long-only bonds a fool’s game because there are alternatives available that provide better yield for similar or lower risk to capital.

One such option is to build a share portfolio of large-cap ‘bond proxy’ companies that are supposedly ‘safe’ and deliver a high and growing dividend yield. After all, the FTSE 100 index is currently yielding 4 per cent against its own historical average of around 3 per cent. On this metric alone, the FTSE 100 index appears good value, although all is not as it seems.

Our in-house research of bond proxy companies has uncovered some startling numbers. First, we took the FTSE 100 index as a whole and measured the recent downturn from its intraday peak to intraday trough. What we found was that it fell by 19 per cent through August. At the same time, the FTSE 250 index only fell by 13.2 per cent. Furthermore, volatility has been considerably higher among large caps. This is the opposite of what we would usually expect when a market corrects.

So what is going on? Well, it gets worse.

The top 20-yielding stocks in the FTSE 100 index (yielding 6.5 per cent) have a combined 2015 peak to trough of 30.8 per cent, more than twice the downside risk of the FTSE 250 index. These stocks have been collectively trading around 30 times price-to-earnings ratio, a metric that is double the FTSE 100 index’s long-term average.

Furthermore, with many of these companies deriving income from slowing emerging markets with devaluing currencies, they face the prospect of dividend cuts and possible downgrades.

So, with bonds and bond proxies presently proving risky places to be, what are the alternatives?

The first step necessary is a shift in thinking. Investors need to stop hunting for the highest yield and should instead focus on total return – for example, lower-yielding safer investments that deliver better capital protection or even some capital growth.