- Interest rates around the world are incredibly low – bonds offer little value.
- Investment dollars flow to where the best opportunities exist.
- Mean reversion is coming – Stocks and dividend payers & growers should be a key beneficiary.
The big question for investors in today’s low interest rate environment is what they should do with their “safe assets” and whether they should invest in bonds. This reminds of the fact that I occasionally I like to end the day with a drink and my preferred fruit juice is the ruby red grapefruit. What kind of drink would it be if I used a grapefruit that had no juice left in it? A bad one is the correct answer.
With rates here and around the world low or in many cases negative, I can’t help but wonder if fixed income investors haven’t squeezed all the fruit (income and low volatility) out of their bond allocation. That’s a real problem for older investors who have come to live on the increasingly small amount of income and stability of their bond returns. All great trends come to an end eventually and I think every investor has to come to grips with the need to find new sources of income and stability. They may even have to assume slightly higher amounts of volatility to ensure their assets grow the way they have grown accustomed to.
With long-term U.S. interest rates trading at roughly 59 basis points and a typical bond fund yielding 1% or less and experiencing frequent bouts of volatility, investors seem to be getting return-less risk from the bond allocation. We all need to do significant research to find attractive fixed income strategies. Return-less risk, I don’t remember seeing that phrase in a bond funds marketing material. The current total return we can expect is likely a far cry from the 5%-7% per year investors have been receiving as interest rates have generally fallen since late 1981 (the best of times) when the 10-year Treasury yield was >15%.
Money Chases Opportunity
Be very careful chasing yield (income) in the global bond market, it could lead you down a very dark path. According to Bloomberg.com, there’s roughly $14 trillion in outstanding bonds with a negative yield. Please think about that for a moment. This is the classic definition of a bubble. Another hint of the bond bubble is that no one seems very worried about the risk of a drawdown in bonds. After all, it’s our safe money, right? The reality: chasing yield in bonds is now a very risky proposition. To get decent income and some capital appreciation, investors may have to take on more risk than they are comfortable taking. When you do not get any health benefits from a “healthy” food, it’s time to find new food types to survive and thrive. If we know money chases opportunities and there are few opportunities in traditional bonds, then we know money will be rotating into other assets in search of better treatment. If a traditional high-net-worth investment portfolio is composed of stocks, bonds, cash, and alternative strategies I suspect the stocks and alts allocations will be the major beneficiary of a secular shift away from fixed income on the margin and on a go-forward basis. To be clear, there will always be opportunities to tactically invest in fixed income asset classes but in my opinion, there are very few buy and hold opportunities in the bond market. We’ve just squeezed most of the fruit out of the grapefruit.
There will always be uncertainty and volatility will always be present, even if it comes in spurts. But do not lose sight of the big picture: there’s a very big wave coming to a few smaller shores and we all have a responsibility to surf those waves because they likely have long tails. When opportunistic assets turn away from a very large market (bonds) and turn to different markets (stocks and alternatives) the flows into the smaller markets can have a disproportionate effect on the future returns of those assets. None of us will see the effect of money flows on a daily basis but over time, the silent flows into stocks and alts could offer investors the returns they need to reach retirement successfully and without the big allocation to fixed income they have traditionally had. Income may come in different forms but at the end of the day, a higher portfolio value from which to draw assets from should be everyone’s goal. Here’s how big the fixed income wave is: $128 trillion in size. The global equity markets are roughly $70 trillion, and the U.S. liquid alternative assets market is roughly $200 billion (source: Morningstar). Just a slight shift from a person or pensions portfolio away from bonds and into stocks or alts can have a wonderful effect on the supply/demand ratios that drive returns.
Long-Term Mean Reversion Favors Stocks and Dividends
Intuitively, we know stocks outperform bonds over time, right? Well, yes and no. The answer to this question depends on the time period we assess. Let’s have some fun and show a 40-year period of the S&P 500 and the long-term Treasury market performance. Again, intuitively the S&P 500 should have outperformed government bonds over such a long period of time. Unfortunately for stocks (blue line), bonds (white line) had the mother of all falling interest rate tailwinds which allowed bond investors to generate strong income and total return from the appreciation that comes when rates fall on a trending basis for 40 years. The largest mean reversion trade in history has likely just begun. With rates basically at zero currently, I think this performance track record will not repeat itself making the safe part a portfolio potentially much riskier than ever before. Buyer beware.
There are plenty of ways to generate the returns and income one needs in retirement. However, we may need to be flexible with regard to how we get our income. Bonds generally yield nothing, particularly after inflation. Most stocks now have higher yields than bonds so dividend payers and those companies that can grow their dividends over time should be the beneficiary of strong money flows. My team and I track all major style factors and the high dividend stocks have performed better than bonds generally but have lagged growth stocks over the recent past. We are currently seeing signs of emerging strength in the dividend stocks broadly as income needs get unmet from bonds. Perhaps we are already seeing the dividend style factor come back in vogue?
The chart below highlights other times like today when the average stock offered a higher yield than U.S. Treasuries. I would argue most stocks, assuming you focus on high quality stocks, are much less risky than government bonds or corporate bonds, and particularly high yield bonds. There’s always exceptions but generally I’ll take the total return potential of a dividend payer or dividend grower plus the actual income over a bond allocation all day long.
I thought it would be fun to look inside our Brands 200 Index and identify the top 25 brands that have attractive revenue growth, high total revenues (speaks to dominance in their category), high Return on Invested Capital (ROIC speaks to being a superior operator), higher than market dividend yield and projected dividend growth, a manageable debt load, and a relatively low beta (lower volatility in stock price over the last 3 years). I would be willing to bet these 25 brands, in aggregate would add more value and total return in the form of dividend income and capital appreciation than a bond portfolio going forward.
Note: The 25 brands include Walmart, Toyota Motor, Exxon, CVS Health, AT&T, Progressive Insurance, Simon Properties, United Healthcare, Apple, Wells Fargo, Chevron, J.P. Morgan Chase, Home Depot, Verizon, IBM, GM, Broadcom, AbbVie Healthcare, Microsoft, Costco, Fox, Taiwan Semiconductor, Kroger, Bank of America, and Merck.
The following are some key takeaway points for investors:
- Because global interest rates are very low or less than zero, forward bond returns should underwhelm on an absolute and relative to history basis.
- On the margin, it won’t take much re-allocation out of bonds and into stocks/alternatives to have a positive effect on those markets.
- The most attractive dividend payers and dividend growers should be a major net beneficiary of the outflows from bonds as investors seek more attractive income and total return.