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Investors are blowing hot, cold, hot on bond proxies

Investors are blowing hot, cold, hot on bond proxies

Investors have enjoyed a love-hate relationship with bond proxies in the past year. From having enthusiastically bought these equities for their bond-like characteristics, they turned against them after Donald Trump’s victory in November 2016’s US presidential election.

Many of the sectors in which these companies are found, such as utilities and tobacco, then came back into favour. But fund managers remain cautious.

Turn the clock back a year and many of these bond proxy names were at high levels, according to Giles Parkinson, manager of the Aviva Global Equity Endurance fund. ‘They faded in the latter half of 2016, a poor performance that accelerated around the US election,’ he said. ‘They stabilised in December and returned to favour in early 2017.’

Prior to the extraordinary past 12 months, bond proxies had performed strongly for several years, according to Simon Murphy, manager of the Old Mutual UK Equity fund. ‘Bond yields were at generational lows. The search for yield outside bond markets led people to equities that exhibited bond-like qualities,’ he said.

Murphy said the main attributes sought by investors were relatively low earnings volatility, strong cash generation and good dividend payments. ‘These firms were rerated upwards because they exhibited those sorts of qualities,’ he said.

‘It was a profitable trade and stretched across many sectors.’ For example, bond proxies could be found in UK consumer staples, with names such as Diageo and Unilever, along with utilities and selected other areas.

This positive environment changed dramatically at the end of last year. ‘When Trump won the election, these shares sold off aggressively as markets reacted to the prospect of more stimuli and higher growth rates by bond yields rising sharply,’ he said.

Investors turned away from bond proxies, companies that benefited from falling bond yields, and into companies that would be bolstered by them rising. ‘There was a very aggressive rotation into banks, life insurers and some of the industrial names during the fourth quarter of last year,’ he added.

Trump doubts

However, the optimism surrounding Trump’s regime faded as investors started to doubt the new administration, according to Matthew Jennings, investment director at Fidelity International.

‘The main reason was Trump’s inability to pass legislation, which a lot of his inflationary, growth-oriented agenda requires,’ he said. ‘If he can’t do it then a lot of these infrastructure projects and tax cuts won’t come to fruition, and growth and inflation won’t come through.’

As a result, investors refocused their attention on bond proxies. Whether they continue to favour these areas will largely depend on the macroeconomic outlook.

Jennings said further outperformance of bond proxies would require falling interest rates, low growth and inflation expectations, and low bond yields. ‘Conversely, a rise in interest rates and inflation expectations would damage the relative performance of bond proxies versus the rest of the market,’ he added.

James de Bunsen, a fund manager in Janus Henderson’s multi-asset team, agreed the global inflation outlook would be key. ‘We face three structural issues that are at least disinflationary, if not deflationary,’ he said.

The first is high debt levels. ‘When people have huge debt servicing costs they spend all their income paying down debt or paying interest,’ he added. Ageing demographics in many markets, and technological disruption, also play their part. ‘Those three factors will play out over decades,’ he added.

The rollercoaster ride endured by bond proxies has affected sectors and individual companies in several ways in recent years. Juliet Schooling Latter, research director of FundCalibre, pointed out tobacco had been lucrative for investors, despite the pressures it has faced around the world.

She said a decade ago everything was going against the sector, with looming legal threats and the introduction in England of a smoking ban in public places. ‘But the big threat of litigation has mostly passed and cigarette companies have grown profits,’ she said. ‘They’ve also cut costs and cashflow is passed to shareholders.’

Mixed performance

Ritu Vohora, investment director at M&G Investments, agreed various companies under the bond proxy umbrella had endured different experiences. ‘It’s been a mixed picture in the year to date, with most bond proxies back in favour.’

There has also been a mixed performance in the technology sector. ‘Healthcare sold off last year on what was going to happen in the White House. But we were positive because you could buy very good companies at better valuations,’ she added.

General valuations across various sectors continue to be a concern. Vohora pointed out company fundamentals have not always backed up the expensive valuations.

‘Even though bond proxies sold off a bit last year they’ve still done very well for the past five or six years and valuations still look quite stretched,’ she said.

She remains cautious and believes careful stock selection will be crucial this year. ‘You need to look at companies in these sectors on their own merits,’ she added.

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James de Bunsen
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