In a perfect world, we would identify a particularly attractive thematic, identify the best companies exposed to those themes through company meetings and our own internal research, and then let the rest of the market play catch up. In practice, however, sometimes our long-term themes persist while the ability to find attractive investment opportunities at the stock level does not. For example, our exposure to the continued growth in the ageing population has been at zero for some time because while one sub-sector is fully valued the other has been hit with regulatory uncertainty. Clearly, this isn’t stopping the global population from getting older on average each year, so we wait patiently for better opportunities to arise.
Similarly, the Fund at times has invested in companies that are positively exposed to the relentless 30yr fall in bond yields. The yield on 10yr government bonds in the US peaked at close to 16% in the early 80’s as energy and wage inflation drove the then Fed chairmen Paul Volcker into a series of rate rises that saw the Fed funds rate rise close to 20% and drove the country into recession. Today the Fed funds rate sits barely above 0% and the yield on 10yr US government bonds is 1.7%. Amazingly, over $13t in government bonds globally are yielding below 0% (i.e. it costs investors to hold them) as central banks fight to drive spending and growth through quantitative easing programs. Valuations of defensive industries have benefitted from this trend given their income stream becomes more attractive the further the return from the risk-free rate falls.
In September these companies were hit by rhetoric from the ECB and the BoJ that their intentions towards asset purchases (bonds) may be changing, given there is a finite number of bonds they can actually buy. As calculated by famed fund manager Ray Dalio of Bridgewater Associates, the ECB may indeed run out of bonds to buy at their current pace within eight months. This potential shift by the central banks saw real rates rise marginally above zero and was amplified by probabilities of the Fed raising their fed funds rate again as near as September, if not December 2016. As the below chart shows, the Fed has continually been more optimistic on the outlook for rate rises for a long time.
Previous periods of investor unease around the tapering of quantitative easing (May 2013 and June 2015) saw yields on US 10yr government bonds rise on average 32% over several months before continuing their march lower. On average in both occasions, Transurban and Sydney Airports fell ~10% in the following month before appreciating in excess of 20% over the next six months. To the middle of September 2016, both stocks had fallen some 15% in a month suggesting to us that any near-term concerns over rising yields (up 15% since July) were priced in. These companies typically trade on a dividend spread relative to bond yields and the below chart shows the spread between the dividend yield and Australian 10yr bond yields over the last two years for both Transurban and Sydney Airport.
What’s clear is that this spread rose significantly in September as the stock prices fell (increasing the dividend yield) while the bond yield also rose, making an investment in these companies relative to the risk-free rate as attractive as any time over the last two years. In the context of a market still generally hunting for income in a low-income world, in September we again were active in taking advantage of compelling short term entry points in yield-related companies. Both Transurban and Sydney Airports are defensive by nature, can grow their free cash flow available for distributions by 5% p.a. and satisfy these payments via their own cash flow. Our view that the Fed would stay put in September and that issues such as poor global growth (the IMF now estimate US GDP of 1.6% for 2016, down from 2.2% in July), a potential Trump presidential victory, the health of Deutsche Bank, a hard Brexit and Italian referendum would continue to weigh on investors, driving a continued demand for defensive, income-producing assets.
It’s important to note that on a long-term view, we do believe we are certainly closer to the end of the bond bull run than the beginning, and eventually this spread could revert higher if bond yields normalise to historic levels. In the short to medium term, this type of normalisation would require stocks to fall over 40%, and bond yields rise 50% to approach the types of relative spreads seen back in 2012. In a world without inflation or growth, this seems unlikely for now. However, in order to provide a level of portfolio protection, we have partially paired our long exposure with shares in similar companies that are exhibiting less favourable dynamics with less ability to withstand any further increase in yields.
Written by Nick Reddaway and contributed by Paragon Funds Management. You can access the latest update here: (VIEW LINK)