An Income Investor’s Guide to the Return of Normal

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.

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.

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.