Investors in ‘defensive’ stocks very popular with equity income funds such as Unilever, Diageo and Imperial Tobacco could be set for significant losses in the event of a bond market sell off, according to Alex Wright, manager of the Fidelity Special Situations fund.
With data from the US showing a robust jobs market, Federal Reserve chief Janet Yellen gave her strongest indication yet that she was looking to raise interest rates in 2015 as numbers from a written statement to the US House of Representatives Financial Services Committee yesterday suggested near full employment.
A US rate rise is seen by many as a looming danger for bond markets with several commentators warning it could act as a catalyst for a sell-off in fixed income as well as stocks that have become closely correlated to their movements – the so called ‘bond proxies’.
These stocks have been popular for a long time with investors due to a widely held belief their highly diversified business are more immune from shocks to the market than most equities as a result of their products’ status as ‘staples’ and the subsequent dividends they produce.
This has also meant they are popular with equity income funds and trusts who place the security of dividends very highly. However, Wight believes that while the dividends may be safe investor’s risk capital loss in the event of a sell-off in bonds as he says their current share prices are artificially high.
Wright (pictured), says many investors in search of a decent yield have fled from bonds and into these stocks, pushing up their share price in the short term but leaving them particularly vulnerable.
“I am shying away from some of the large cap defensive stocks. It is the key place where I don't own stocks. I won’t own any of the large utilities, I don’t own any of the large staple companies - those are very expensive stocks,” he said.“Generally they have quite high margins and high returns but are too well-owned and there is no real positive change story and therefore I shy away from owning any of these.”
“While these stocks have been historically viewed as safe, in a bond sell off – which may or may not happen – I don’t think they would be particularly safe and therefore I am very much staying away. They have limited upside because of their high valuation and actually offer quite large downside.”
According to FE Analytics, Unilever, Diageo, Imperial Tobacco and British American Tobacco have all rallied significantly harder than the FTSE 100 since the nadir of the financial crisis back in 2009 when quantitative easing was first implemented.
Performance of stocks versus index since 2009
Source: FE Analytics
Wright says the relationship with these stocks has become closely correlated, pointing to the graph below which shows the movement of Unilever against the US 10 year government bond yield’s movements.
Performance stock and index since January 2014
Source: Fidelity
“You can see reasonably tight correlation there. Effectively because bond yields are very low, some traditional bond investors have been chased into the equity space and chased valuations to the very high levels,” Wright said.
Of the 85 funds in the IA UK Equity Income sector 38 have a top 10 holding in Imperial Tobacco, 15 in Unilever, 27 British American Tobacco and two hold Diageo.
The £312m Evenlode Income fund, managed by Hugh Yarrow, is one of the most exposed to these four stocks with 24 four per cent of the portfolio split between them.
Wright, who is an FE Alpha, has managed the £3bn Fidelity Special Situations fund since the beginning of 2014 and despite a wobbly start throughout most of 2014 he has bounced back and is currently outperforming sector and benchmark.
Performance of fund, sector and index since January 2014
Source: FE Analytics
He tends to favour unloved and bombed-out companies in sectors that are out of favour amongst many investors and holding them until their potential value is recognised by the wider market but he says he is still keen to own some defensive names to protect against falls.
“I have bought some defensive stocks - there are some cheaper ones down the market cap spectrum that I think are still being overlooked and you can still get decent yield in smaller companies,” he said.
“You can still find less cyclical stocks on reasonable valuations but they are not the obvious candidates in the market. I have taken that money and put it into the small mid and small caps. There are some defensive mid-caps you can but into.”
Jamie Forbes-Wilson, manager of the AXA Framlington Blue Chip Equity Income fund is also wary on large cap defensives and is avoiding the consumer goods space as a result.
“Consumer staples are, generally speaking, very expensive. I don’t hold much in the sector and have no exposure to the likes of Unilever or Diageo,” he said.
“When it comes to those two companies, I don’t want to own stocks which give me a yield of 2 to 3 per cent (so below market average), low growth potential and historically high valuations. I don’t want to hide in these bond proxies as I see better opportunities elsewhere and they are going to suffer in a rising interest rate environment.”