An Income Investor’s Guide to the Return of Normal

December 6, 2022 | By: Stephen Duench, Andy Kochar, David Stonehouse, Stephen Way

An Income Investor’s Guide to the Return of Normal

Yield is back. So, what does that mean for investors and portfolio construction? Members of AGF's Investment Management team sit down to explore the question and discuss opportunities across asset classes.


What has changed for investors seeking yield from bonds over the past year?

David Stonehouse (DS): Inflation ended up being more of a challenge than pretty much everyone anticipated 12 months ago, even for those of us who thought it would be more persistent than transitory. In fact, some central banks still considered the rise in prices to be transitory around this time last year, and the U.S. Federal Reserve hadn’t even started raising interest rates to try and combat them.

Of course, that stance was soon abandoned, but, once again, not in the measured way most people anticipated. Instead, inflation has remained stubbornly high which has led to an explosive rise in yields that has been unlike anything we’ve experienced in several decades. A typical rate cycle, for instance, might see yields rise a couple of percentage points, but this time they’ve climbed the better part of four percentage points.

Andy Kochar (AK): We’ve had a definite regime change in markets. Investors needed to “chase” performance and accept a much higher volatility to achieve their long-term objectives over the past decade. But with the significant re-pricing of real interest rates this year, that is no longer necessary. Income is the most certain element of a return profile and, when you have enough of it, there should be less need for excessive risk taking.

DS: That’s created a dynamic we have not seen since before the Global Financial Crisis. While in the past 15 years or so, yields have averaged less than 3% – and fallen to zero at times – now we’ve got sovereign bonds yielding 4 to 5%, or close to it, in some countries, and other categories of fixed income like corporate credit and EM debt yielding even more.

AK: Even when central banks start cutting rates again, they’re not likely to fall back to zero. What income investors dealt with over the past decade (i.e., ultra low bond yields) was atypical from a historical perspective and today’s higher-yielding environment should be considered a return to normal.

DS: By extension, what has emerged is the return of a more competitive income environment that didn’t exist a year ago. In other words, with bonds now paying mid-single digit returns or better, some investors are bound to reconsider their allocation to stocks going forward.

How would you describe the current backdrop for dividend stocks?

Stephen Way (SW): Bond yields are more attractive in relation to dividend yields than they’ve been in some time, but that doesn’t mean an either/or scenario is necessarily at play for investors. If you go back to the 1990s, equity markets performed extremely well despite U.S. bonds yielding 200 to 400 basis points above U.S. dividend stocks for good parts of the decade.

Stephen Duench (SD): The selloff in equity markets this year has created some attractive dividend yield opportunities, but there’s no question that it’s harder to find stocks that yield more than bond yields than it was when interest rates were near zero. The relative advantage of dividend stocks still exists across certain geographies and sectors of the market, but it’s far less prevalent now that bond yields have risen so much.

Dividend Yield vs U.S. 10-year Treasury Yields

A graph showing Dividend Yield vs U.S. 10-year Treasury Yields

Source: AGF Investments Inc. using data from FactSet as of November 16, 2022.

SW: One of the attractive characteristics of dividend stocks that often gets overlooked is the potential growth in them over time. The MSCI World Index is expected to grow its average dividend by 6% over the next three years, which gives you a level of protection against inflation that you don’t necessarily get with bond yields. Companies that grow their dividends on a consistent basis also tend to be more disciplined and of higher quality, which can result in less volatility over time.

Where do you see the best opportunities to pick up yield in your respective asset classes?

AK: Everything we’ve talked about so far means that large pools of capital need to be rethought. On the fixed income side, that’s true of government, provincial and municipal bonds, but also investment grade and high-yield credit as well as Emerging Market debt. Yes, there is a chance that central banks are going to overshoot, so some of these buckets are going to seem too good to be true. But overall, investors no longer need to reach for yield, meaning they can focus on higher-quality issues across the fixed income spectrum going forward.

DS: It’s important to note that bond yields usually rise because the economy is particularly strong. Moreover, companies also look strong in that kind of economic environment and it’s usual for spreads between government bonds and corporate credit to tighten. Conversely, when bond yields are falling, it may portend more challenging economic times ahead and spreads widen.

But this past year has been different. As underlying interest rates were reset higher, riskier fixed income assets did too, which resulted in spreads widening, not getting tighter. So, not only are sovereign yields more attractive than they were a year ago, investment grade and high-yield issues are too. Plus, as Andy points out, investors can find quality companies that are paying close to 7% in yield and don’t have the same risk as companies they may have owned in the past just to get a yield of 3% – or even less in some instances.

SD: From a dividend perspective, there are regions globally, including the United Kingdom, Europe and Canada, where dividends still have the yield advantage over bonds in select industries. Importantly, this advantage can be found in some of the more defensive areas of the market that can help protect against the possibility of further downside, as well as in cyclicals like life insurance, banks and even real estate investment trusts (REITs) that could benefit from a more positive turn in the New Year.

Canadian Dividend Yields vs. 10-Year Canadian Government Bonds

A graph showing Canadian Dividend Yields vs. 10-Year Canadian Government Bonds

Source: AGF Investments Inc. using data from FactSet as of November 16, 2022.

SW: The areas where you have dividend yield right now – Energy and Materials – are not a slam dunk depending on what happens to commodity prices next year, but reducing volatility through dividends over the next six months will be important in a climate of negative earnings revisions.  

SD: Another potential catalyst for dividend stocks going forward relates to tax changes on share repurchases both here in Canada and in the United States. Companies may decide to bulk up their dividends instead of doing more buybacks.

SW: It’s also important to note that, over the past decade, a lot of dividend investors bought lower-yielding securities that were growing their dividend at a fast pace, but they weren’t buying it for the yield per se; they were buying it for the growth. I think now you’re going to get more people structuring their dividend portfolios differently, with more emphasis on the yield component, because you’re not striving for an 8% or 12% rate of return to compete against the broader equity market.

DS: The other potential benefit of bonds right now is the cushion they afford against recession. That wasn’t the case when yields were at 1% or less. There just wasn’t much room for them to go lower without going negative (which, of course, they did in some cases). Yet, now, yields could easily drop 1% in an economic downturn, and not only will an investor still clip a coupon of 4%, but they also stand to make, say, a 6% return from the capital appreciation in the price of the bond. That means a net gain closer to 10%, so, you’re not just getting income or compensation for inflation, you’re getting better potential downside protection as well. 

AK: Just like the good old days.

SW: Especially if you get a real positive yield based on actual realized inflation. That would truly be a “back to normal” environment, and that’s where we should be. There’s no good reason for negative real yields.

Does the current environment for yield dictate a different approach to asset allocation?

DS: My thinking is that 50/50 could be the new 60/40 – especially if an investor’s goal is to achieve a realistic portfolio return of 7% annually. After all, they can now get 5% to 6% from the fixed-income side of the equation, so they only need 8% to 9% from the equity side. Moreover, if one-third of that equity return can be had through dividends, then the capital appreciation requirement is relatively modest and certainly more achievable.

SD: A more balanced approach between equities and bonds is going to be important going forward. A weighting towards dividend stocks, for instance, should give investors the protection they need in the case that inflation remains high, while a weighting towards bonds could be critical in the case of a recession.   

DS: It’s not necessarily all income all the time – and there are various tax implications to consider – but it’s a far more appealing environment for asset allocators who no longer want to focus so heavily on capital appreciation to achieve their objectives.  

SW: Of course, a lot of what we’ve been saying today will depend on the economic backdrop that’s been driving the shifting environment for yield this year. Rates have been rising because of inflation expectations and realized inflation being way higher than anybody anticipated. And there is an underlying belief that central banks will get inflation under control. But the question is whether inflation comes down to a range of 4% to 5% in countries like the U.S. or a range of 2% to 3%. It doesn’t seem like much, but it can make a big difference in terms of how you approach asset allocation and where the best opportunities for yield can be found going forward.

Stephen Duench
Stephen Duench, CFA®
Co Head, Highstreet Private Client † & VP and Portfolio Manager, AGF Investments Inc.
AGF Investments Inc.
Andy Kochar
Andy Kochar, CFA®
Vice-President, Portfolio Manager and Head of Global Credit
AGF Investments LLC
David Stonehouse
David Stonehouse, MBA, CFA®
SVP & Head of North American and Specialty Investments
AGF Investments Inc.
Stephen Way
Stephen Way, CFA®
SVP and Head of Global & Emerging Markets Equities
AGF Investments Inc.
Co Head, Highstreet Private Client † & VP and Portfolio Manager, AGF Investments Inc.

As Vice-President and Portfolio Manager, Stephen Duench is a key contributor to AGF’s quantitative investment platform. AGF’s Quantitative Investing team is grounded in the belief that investment outcomes can be improved by assessing and targeting the factors that drive market returns. Stephen is the lead Portfolio Manager of the AGF Canadian Dividend Income Fund and AGF North American Dividend Income Fund and is central to the creation and support of AGF’s portfolio management tools, analysis and applications across both Canadian and global mandates.

He began his career with AGF as part of the Highstreet† Investment Management team, involved in the management of both public equity and fixed income institutional and high-net worth portfolios. Stephen now serves as co-head of Highstreet Private Client, leading the firm’s strategy around investment management and allocation across multiple asset classes.

Stephen earned an Honours degree in Financial Mathematics from Wilfrid Laurier University and is a CFA® charterholder.

† Highstreet Asset Management Inc. is a wholly-owned subsidiary of AGF Investments Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. Pursuant to exemptive relief, Stephen Duench and Mark Stacey are dually registered as advising representatives of Highstreet Asset Management Inc. and AGF Investments Inc., Highstreet's parent company.

Vice-President, Portfolio Manager and Head of Global Credit

Andy Kochar is a principal member of AGF’s Fixed Income Team and serves as the firm’s head of global credit. Using a cross-asset framework, Andy is responsible for the research and allocation of credit risk across all of AGF’s fixed income portfolios.

He previously served as Associate Portfolio Manager for AGF’s credit-oriented portfolios from 2013 to 2018. Prior to that, for more than five years, Andy served as Investment Analyst, Credit Research at Acuity Investment Management, which was acquired by AGF in 2011.

Andy earned a B.A. in Economics (Cum Laude) from York University and he is a CFA® charterholder.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

SVP & Head of North American and Specialty Investments

David Stonehouse oversees AGF’s North American and Specialty Investments teams while maintaining direct portfolio management responsibilities for his current mandates.

With nearly three decades of experience managing both fixed income and balanced mandates, David employs a rigorous and disciplined investment process combining a top-down approach to duration and asset allocation with a bottom-up approach to security selection. David is a member of The Office of the CIO – a structure within AGF’s Investment Management team. This leadership structure encourages and further embeds collaboration and active accountability across the Investment Management team and the broader organization.

David received a B.Sc. in Applied Science from Queen’s University, an MBA in Finance and Accounting from McMaster University and is a CFA® charterholder.

Registered as a Portfolio Manager under AGF Investments Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

SVP and Head of Global & Emerging Markets Equities

Steve Way leads portfolio management responsibilities for global equity and global dividend mandates at AGF. As the architect of the Economic Value Added (EVA)-based investment process used for these industry-leading mandates, he is supported by a team that uses its collective experience to locate opportunities unrecognized by the market. Steve is a member of The Office of the CIO – a structure within AGF’s Investment Management team. This leadership structure encourages and further embeds collaboration and active accountability across the Investment Management team and the broader organization. He is also a member of the AGF Asset Allocation Committee (AAC), which consists of senior portfolio managers who are responsible for various regions and asset classes. The AAC meets regularly to discuss, analyze and assess the macro-economic environment and capital markets in order to determine optimal asset allocation recommendations.

Steve’s industry experience began when he joined AGF in 1987. In 1991, he established AGF’s wholly owned subsidiary AGF International Advisors Company Limited in Dublin, Ireland and ran the operations as Managing Director until 1994.

Steve holds a B.A. in Administrative and Commercial Studies from the University of Western Ontario. He is a CFA® charterholder and a member of CFA® Society Toronto.

Registered as a Portfolio Manager under AGF Investments Inc. and AGF Investment America Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

The views expressed in this document are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.

The commentaries contained herein are provided as a general source of information based on information available as of December 6, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.

This document may contain forward-looking information that reflects our current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties, and assumptions that could cause actual results to differ materially from those expressed herein.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Investments LLC (AGFUS) and AGF International Advisors Company Limited (AGFIA). AGFA and AGFUS are registered advisors in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income, and balanced assets.

This document is for use by Canadian accredited investors, European professional investors, U.S. institutional investors or for advisors to support the assessment of investment suitability for investors.

® The “AGF” logo is a registered trademark of AGF Management Limited and used under licence.

RO: 20221201-2616672

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