Income investors in UK ‘bond proxy’ stocks should not panic sell, despite concerns about they will hold up in a rising interest rate environment, according to Woodford Investment Management.
After several decades of almost uninterrupted progress, fixed income markets have started to come under pressure in recent months and have lost money since February.
Performance of indices in 2015
Source: FE Analytics
This has led a number of fund managers to warn that so-called ‘bond proxies’ – equities such as the likes of Unilever and Diageo that are bought for their dividends in the absence of suitably priced bonds – are set for sell-off in the near future as central banks led by the Federal Reserve gear up to raise interest rates from their current historic lows.
The likes of GLG’s Henry Dixon and Ruffer’s Steve Russell have warned that UK equity income funds are likely to be set for a rough ride in the event that a sell-off in the bond market, prompted by interest rate fears, spills over into the equity market.
But these fears are both incorrect and illogical, says Mitchell Fraser-Jones of Woodford Investment Management, the fund business set up by UK equity income star Neil Woodford.
“We do not think there will be a prolonged sell-off in bond markets – at least, not yet. Credit markets are in dangerous valuation territory where capital losses ultimately look inevitable in the long term,” he said.
“In the meantime, however, with the demand for fixed interest securities remaining strong and economic fundamentals remaining weak, we believe bond yields could revisit their lows in the months ahead.”
While FE Alpha Manager Woodford’s £5.7bn CF Woodford Equity Income fund is stuffed with defensive stocks such as Imperial Tobacco, British American Tobacco and Reynolds American, Mitchell Jones adds that the portfolio has resistance to a sell-off in bonds.
“Another reason we do not fear a ‘bond proxy’ effect on the portfolio involves valuation. If equities with bond-like characteristics traded on the same valuation as bonds, there would be reason to worry,” he explained.
“Arguably, some equities do and many others are over-valued in our view, but, importantly, not the ones that we have invested in. As far as income investing is concerned, we are attracted to investment opportunities where the starting dividend yield is attractive and where we are confident about the prospect of sustainable long-term dividend growth.”
“Those two features provide fundamental security to the portfolio. If there was a continued correction in bond markets in the near term, the portfolio could be affected by sentiment towards ‘bond proxies’ but, longer term, there is still a fundamental valuation attraction to all of the stocks that we have invested in.”
However Mitchell Jones says the fund’s team is paying close attention to activities in the bond market, particularly in light of the recent leap in German government bonds’ yield from 0.08 per cent to 0.72 per cent in less than a month.
“We always pay close attention to the behaviour of bond markets. The fixed interest asset class is much more interested in reading the pulse of the real economy and tends to be much better and faster at pricing in macroeconomic developments than the equity asset class.”
“Nevertheless, the bond market isn’t always right and does sometimes send false signals. The reasons behind the recent bond market sell-off, for instance, have been hard to fathom. Some have suggested the European sovereign bond market’s recent correction was prompted by underlying improvements in the eurozone economy.”
“Others have suggested that, as a result of a pickup in the oil price, it is indicative of diminishing fears of deflation or even a renewed bout of inflation in the western world.”
However, he says the bond market correction happened because investors were moving money away from the asset class after its previous rally and was not indicative of a change in fundamentals.
“European sovereign bonds and other related credit markets have been in huge demand as a popular way of ‘trading’ the arrival of European QE. This triggered a rally in which some markets became over-extended and, initially, the sell-off corrected that. The initial move probably alarmed some participants out of this crowded trade, which simply exacerbated the speed and scale of the correction.”
Mitchell Jones says that with continuing low yields in the bond markets investors can expect good prospects from bond proxies, broadly speaking, as the hunt for yield continues to be well-populated.
“Ultimately, equities and bonds are quite similar beasts. All dividend-bearing equities can be considered to have ‘bond-like characteristics’ – they should be viewed as bonds with variable coupons and no predetermined maturity.”
“This makes equities a less ‘certain’ proposition than bonds but, in the current valuation context, equity investors should be well-rewarded in the long term for embracing that uncertainty, particularly in businesses that can provide sustainable dividend growth going forward.”
