The widespread use of the term ‘bond proxy’ could put investors’ portfolios in jeopardy and cause them to miss out on growth, income and stability during today’s challenging climate, according to several fund managers. 
Some also say that, while the value/growth market rotation has pulled back so far this year, there are still some buying opportunities for those looking to increase their quality exposure as some stocks have been unfairly labelled.
“I think the use of the expression ‘bond proxy’ is quite dangerous because I think it tends to conflate several different equity characteristics and lump them all together,” Patrick Barton (pictured), who runs the four crown-rated CFIC CRUX UK fund, said.
“We read about these ‘expensive defensives’ and ‘bond proxies’ in the media, but which stocks are we talking about?
“If you’re talking about utilities and real estate which are semi-legitimate bond proxies, those are the types of stocks that desperate fixed income investors have been migrating into. That’s dangerous because they aren’t natural holders and they might not be looking at those in quite the right way – as equities – because they were fixed income investors.”
Throughout most of last year, quality growth stocks snowballed in popularity due to a torrid combination of geopolitical instability and ultra-low interest rates, which exacerbated the mass hunt for income.
However, the election of US president Donald Trump in November last year added fuel to the fire for those anticipating higher inflation and global growth which, combined with toppy valuations across many dividend-paying mega-caps, led to an aggressive rotation from growth into value.
Performance of indices over 1yr
Source: FE Analytics
This trend has indeed reversed year-to-date as bond yields have dipped, with the FTSE World Growth index outperforming its FTSE World Value counterpart by more than seven times in 2017 so far.
Is this a blip in the continuation of a value rally, or should investors retain their exposure to high-quality dividend-payers?
Alan Dobbie, manager of the four crown-rated Rathbone Blue Chip Income and Growth fund, says it is prudent to hold quality stocks that aren’t bond proxies – a task he believes is wrongly labelled as counterintuitive.
“We differentiate between bond proxies and what we call ‘compounders’, which are stocks with a high return on capital and have the ability to reinvest back into the businesses, so Sage or Unilever for instance,” he said.
“Some people would call those bond proxies, but I would say they’re more like an inflation-linked bond because they have a growing top-line and they have the ability to reinvest higher rates of return.
“Cash cows are what we would class as bond proxies. These tend to fall under the telecom or utilities sectors. They’re businesses which generate high returns but don’t have the ability to reinvest back into their businesses, so they’re not growing but they’re generating a lot of cash.”
Dobbie says that, given his long-term time horizon, he is more interested in businesses that offer structural growth opportunities rather than those that are simply paying high yields. As such, he currently has a zero per cent weighting in telecoms (although he wouldn’t strictly rule out holding anything from this sector in the future) and is significantly underweight utilities relative to the FTSE All Share index.
“It’s much more about high cash flow than it is about a high yield,” he added. “We want them to pay some of that cash flow back to us as dividends but we want them to reinvest back into their business for growth.”
Dominic Neary, manager of the Scottish American Investment Company, agrees and says that now is a particularly important time to minimise portfolio risk and opt for quality given the challenging macroeconomic backdrop.
“What we call ‘compounding machines’ are the core of the portfolio,” he said. “Whenever you’re investing from the bottom up, you find that when you look from the top down, it is reflecting quite a lot of your world view.
“What you’ll have seen in the change in nature of the portfolio is that the ‘compounding machine’ element has increased from 55 per cent three or four years ago to nearly 70 per cent today, which I think is recognition of the fact that in a lot of the other categories you have a higher inherent risk.”
He says it is a common misconception that these ‘compounding machines’ are nothing more than bond proxies, which are overpriced and carry valuation risk.
“This is something we’re very, very conscious of,” Neary continued. “The one difference we would really highlight is our focus on growth. We feel that you should look at growth and the dependability of growth, so even when you’re aiming for a 3 per cent yield and upwards, there will always be a different balance between three concepts – growth, income and dependability.
“Predominantly, what you’ll see in the portfolio is a much ‘growthier’ aspect than what you would see in a bond proxy portfolio. We have minimal telcos and, when we do, it tends to be because it demonstrates profitability transformation.”
Dan Roberts, manager of the four crown-rated Fidelity Global Dividend fund, says last year’s indiscriminate selling of so-called ‘bond proxies’ by the wider market has opened up some attractive buying opportunities.
“Investors have recently tended to label all secure dividend-paying stocks with defensive, low volatility, quality characteristics as bond proxies. At a broad sector level, this resulted in staples, utilities, telecoms and healthcare all struggling over the second half of last year,” he explained.
Performance of indices in Q3 and Q4 2016
Source: FE Analytics
“But scratch only a little beneath the surface and it can be seen that these sectors and the companies operating within them have very different characteristics in terms of duration, growth and absolute level of dividend yield.
“Indeed, many quality stocks have been unfairly caught up in this broad market rotation and this has actually created some interesting buying opportunities over the first quarter of 2017.”
Roberts believes that IT services company Wolters Kluwer is a good example of this, as its share price has fallen by 20 per cent from a peak where it was still only ever trading at a discount to market.
He says it offers high and stable margins, recurring revenues and a strong balance sheet. He adds that it is also set to benefit from a stronger US economy as more than 75 per cent of its profits are derived from there.
“Consumer company Diageo is another quality stock that has been unjustly labelled as a bond proxy,” he explained. “Indeed, it has consistently grown its dividend - in stark contrast to a bond that offers no growth in its coupon.
“Recent moves have left it looking attractively valued given its strong network of consumer brands such as Smirnoff and Gordon’s Gin which command pricing power and are likely to be around for decades to come.
“This preference for quality stocks is permanent and not tactical. I believe it stands the fund in good stead to continue to deliver an attractive dividend-based total return over a full market cycle.”