Signs of a sell-off in the yield trade have been increasingly noticeable over the last few months, according to Rathbones’ David Coombs (pictured). 
The manager, who runs Rathbone Strategic Growth Portfolio among other funds, has therefore been repositioning away from high-yielding income funds and into lower-yielding funds that are focused on dividend growth.
“Bond proxy-type stocks have started to become a bit more volatile – we’re starting to question at last whether these valuations are a bit stretched. Also, you’re seeing higher volatility in bond markets and it just feels that the end is in sight in terms of the never-ending rise in these sorts of stocks and asset classes,” he said.
High-yielding defensive equities, or ‘bond proxies’, have increased in popularity over recent years after quantitative easing pushing down yields in fixed income markets and pushing investors into stocks.
Many investors are therefore turning to the equity income sector in the hunt for yield, with blue chip stocks such as Royal Dutch Shell and BP returning attractive dividend yields of more than 6 per cent.
According to the latest data released from the Investment Association, IA UK Equity Income was the highest-selling sector in May and saw net retail sales of £419m, which is the highest cash inflow it has seen since December last year.
Performance of sectors vs index in 2015
Source: FE Analytics
In an article published on Friday, Lazard’s Alan Custis told FE Trustnet that he was also increasing his exposure to high-yielding large-caps.
“When you look at the dividends yields relative to the STOXX 600 we’re back to something we last saw in the latter part of two decades ago in the late 90s, at which point the mining sector performed very well off that last dividend,” he pointed out.
“The last time we saw this sort of dividend yield relative, we were at the point at which we saw some fairly strong share price performance, and you can say the same for price-to-book [ratio], which is again getting back to the levels we saw 20-odd years ago.”
Coombs also says that it is the threat of a rate hike that has stimulated an increased weakness in higher-dividend stocks.
“You’re seeing yields compress significantly, so it’s more about starting to see early signs. You can’t say it’s a big sell-off but there are signs that people are starting to question whether some of these valuations are sustainable in a rising interest rate environment,” he said.
As such, the manager is shifting his focus to growth and value investment opportunities as opposed to income, recently buying into Kiltearn Global Equity, which is Dublin-domiciled and run by Murdo Murchison.
The ‘off-the-radar’ fund, which focuses on bottom-quartile valuations, runs screens on price/book, price/earnings and dividend-yield metrics when choosing stocks.
“It actually has no yield at all, it’s a value fund. This is in my Total Return fund, which is my lower-risk strategy,” Coombs said.
“Normally I run my equity positions into equity income strategies because they tend to have a lower beta and slightly lower risk. But given that I think some of the stocks in some of those funds are now looking stretched on a valuation basis from years of outperformance, I’ve wanted to reduce my exposure to global income funds and move into value funds in my Total Return fund, and move more to growth funds in my higher-risk funds.”
Now that he is trimming his exposure to open-ended income funds, the manager is seeing opportunities in closed-ended investment vehicles and has boosted holdings in several investment trusts, due to their widening discounts.
The trades have taken place in his £118m Rathbone Global Alpha fund, which is a pension fund and aims to achieve above-average growth over a long-term time horizon.
“In March, a lot of the UK equity income [closed-ended] funds, which I’ve been looking at for quite some time on premiums, went to discounts. Things like Temple Bar, Lowland, Murray Income – quite a few funds in the sector went to discounts at around the same time,” Coombs explained.
“I’ve been picking those as the yields have been pushed up because they’re on discounts. Long term, I still think an equity income strategy is the most attractive, but short term I’m just concerned. When a top manager at Veritas is holding less and less stocks in the portfolio, you do worry that some of these managers are struggling to populate their portfolios with new ideas.”
“Markets are obviously pretty fully-valued and yielding sectors such as REITs, utilities and tobacco have really run and run. I’m just wondering if we’ve started to see that roll over the last couple of months.”
Coombs, who joined Rathbones in 2007 and is a member of its investment executive committee, is the lead manager for the Rathbone multi-asset portfolios and also co-manages the Rathbone Strategic Bond fund.
The manager has outperformed his peer group composite by 4.86 percentage points over five years.
Performance of manager vs peer group composite over five years
Source: FE Analytics