Investors should beware a looming crash in so-called ‘bond proxy’ stocks – the likes of Unilever and Diageo – due to a budding shake up in the bond market, according to GLG’s Henry Dixon, although star manager Nick Train remains confident such stocks can continue to thrive.
Bond proxies – defensive equities with high yields such as consumer staples and utilities companies – have been very popular with income-seeking investors in recent years who have found a dearth of opportunity in the more generic fixed income market, which as the graph below shows has seen huge gains over the past few decades, pushing yields down to record lows.
Performance of indices over 20 years
Source: FE Analytics
However Dixon, who manages the £300m GLG Undervalued Assets and £100m GLG UK Income funds, warns that many of these companies face significant downside in the coming six months or so as volatility returns to bond yields and inflation data starts to reverse from a disinflationary period.
“We are very, very excited. There is going to be an amazing tug of war in the market with the first building block being the [current] insanity of the bond market and how that then filters through into the equity market. We will have to be very, very nimble and play our way through it,” he said.
“You have definitely had a change of trend. It is actually quite amusing when people talk of no liquidity in the bond market. If you rewind a week you could have liquidated your entire position in German bunds at 15 basis points now because it has hit that first bump in the road, liquidity has dried up.”
“That doesn’t leave the bond market in a good place fundamentally. Bond yields could rise from the lows of 1.5 and potentially double because of inflation data that we could get in December/January. It would then follow that shares that have enjoyed ratings of 25-30 times could see five of their P/E points disapear very quickly.”
Therefore, he says investors could be looking at 20 per cent downside in these types of bond proxies.
In contrast FE Alpha Manager Nick Train, who runs the £1.5bn CF Lindsell Train UK Equity fund, says worries over bond proxies are overblown.
“There are today a number of reasons to be cautious of our strategy and, indeed, many equity strategies. But the risk of falling bond prices and rising inflation is not one that keeps us awake at night,” Train said.
“A number of our holdings are categorised by other investors as bond proxies, by which they mean, we think, that their share prices are dictated by the rise and fall of bond prices above any other factor.”
“Now it would be idle of us to deny that bond prices are irrelevant for our portfolio. We use bond yields ourselves in valuation work and the lower those yields go the higher the warranted valuations we come up with.”
However, Train says he takes two distinct issues with the argument that these companies are set for a rough ride in the medium term.
“First, if a share is really a bond proxy it must have qualities similar to a bond. The most notable characteristic of a conventional government bond is that it has a fixed, unchanging coupon. But our holdings most often cited in this context – Diageo, Heineken, Unilever – do not have fixed dividends.”
"They have, instead, long histories of real, inflation-beating dividend growth and, in our opinion, plenty of scope to maintain these records. If there is anything 'bond-like' about such companies, then actually the bonds they most closely resemble are index-linked government bonds, not conventionals.”
“Second, history also teaches that the type of companies that suffer most operational damage during periods of rising inflation are capital intensive suppliers of commodity products.”
According to FE Analytics, the likes of Diageo and Unilever have enjoyed a rapid rise since markets bottomed out in 2009 and vastly outperformed the FTSE 100, although the past two years have seen a more sideways trend for the two stocks while the index as a whole has ground further upwards. In the case of Diageo, 2015 has brought an almost 10 per cent fall in its share price.
Performance of stocks over 6yrs
Source: FE Analytics
Dixon, who is also an FE Alpha Manager, says the past two years have been a particularly expensive time for the FTSE 100 and, accompanied by ever falling yields, has meant investors have become willing ignorant of fundamentals in the search for a decent yield.
“Since May of 2013 the FTSE 100 has been fully valued but we are approaching a period that we are very excited about where there is going to be a lot of stress creep into the system, which if you are nimble is definitely interesting times,” Dixon said.
"In many ways I am very pleased there is stress creeping back in because I think, as a reasonably rational man, I have struggled to explain events in the bond market this year and it will be a really interesting few months."
He says investors can look out for two potential triggers: inflation rising and rising growth in the real economy.
“What will guide it will be two things: the inflation data - in December/January - and clearly we cannot deny that we have had some disappointing GDP numbers in the UK and US which, should we see acceleration of GDP in the second half of the year, means there is a twin spectre of rising growth and inflation.”
“Things very definitely go in cycles and the bond market has very definitely overreacted to arithmetic deflation that has been brought to us by falling oil. It is therefore very likely that it will overreact to arithmetic inflation which is absolutely guaranteed to be on our screens come January of next year.”
Dixon says we could see inflation, as measured by the consumer prices index (CPI), rise to almost 3 per cent by this time.
“How will the market react to that, will it think we have an inflation problem? All we can say is that some sense of reality has returned to the bond market and the equity market cannot escape unscathed because too much of the equity market is - effectively - a bond or is at least priced like one because so much of the equity market has ceased to represent reality based on fundamentals.”
“You're also looking at a zombie yield part of the market such utilities where the fundamentals don't look fantastic. Those yields are going to start to look progressively less attractive.”
