There is no alternative (TINA): the shift from bonds to equities
Bond yields are set to remain extremely low for a long time. The hunt for yield will continue to whet investor appetite for high, safe and growing dividend stocks, which are known as ‘dividend aristocrats’. In the long run, this universe offers a better risk/return ratio than the equity market as a whole. However, investors must pay the price of higher volatility compared with bonds and be willing to invest over the long term.
This theme mainly concerns investments in developed markets. In this space, the problem of squeezed bond yields is widespread. In euros, this issue is particularly acute with negative yields on the lion's share of Government bonds and on around 40% of Corporate bonds. The dividend yield is very attractive, i.e. above 3%. For bonds in dollar terms (if we exclude 2009), the yield differential has never been so favourable. This theme is proving an attractive alternative for investors looking for steady income, as long as they invest over the long term and accept higher volatility than that in the bond market.
Never have official rates and bond yields been as ridiculously low as they are today. Indeed one third of developed market Government bonds offer a negative yield, and one-half offer a yield of less than 1%. This dearth of steady income is set to persist in the environment of sluggish growth and low inflation. This is a crucial issue for the vast majority of investors (private and institutional), as generating regular income is at the top of their investment objectives. This problem can only get worse with the ageing population, exacerbated by longer retirements and hence a longer period to pay pensions.
The regular yield differential between bonds and equities has rarely been so much in favour of the latter, especially in euros. Investors seeking regular income can thus seriously consider shares, especially those with high dividends. Investment choices must, however, be well targeted. A study by Fama & French (covering the period from 1928 to 2013) shows that selecting the quintile with stocks offering the highest dividend yields is not the best strategy because the investor could be exposed to a ‘value trap’, or to companies that could reduce their dividends.
An ideal strategy is to select companies with high, secure and growing dividends. These are known as ‘dividend aristocrats’. To be part of this exclusive club, dividends need to have risen every year for the past 25 years! In terms of characteristics, this universe contains many more Investment Grade companies than the underlying index, and is more balanced between the value and growth styles. Another positive characteristic is that over the long term, the ‘aristocrats’ outperform the equity market as a whole while exposing the investor to lower volatility. In other words, the ‘aristocrats’ offer a better Sharpe ratio.
The price paid for investing in this universe is the acceptance of a much higher volatility than in the bond markets and a long-term investment horizon. For example, with an investment horizon of 10 years, an investor can afford to lose more than 20% on his dividend ‘aristocrats’ and enjoy a performance that continues to outperform fixed-income investments. The performance advantage would grow significantly if we consider that dividends tend to rise while bond yields are fixed. It also means that ‘dividend aristocrats’ would offer a better protection against inflation if the latter were to rise.
The hunt for steady income in recent years has clearly driven up equity valuations. As the bond yield squeeze is set to persist for a long time, the demand for ‘dividend aristocrats’ will remain strong and valuations will remain above their long-term averages.
Another supporting factor for the ‘dividend aristocrats’ is the moderate upside potential in equity markets. This stems from already high-profit margins and valuations, which reflect widely positive expectations. Dividends will thus play a major role in the next few years in the total return of stock market investments.
The main risk relates to the economic climate. If a recession were to occur, there would be a risk of capital loss. Only the end to that recession would reduce the loss. Hence, it is important to have a long-term investment horizon to mitigate any disruption to the business cycle. Structural advantages may thus emerge. A related risk is if protectionist trends and trade tensions escalate further.
A minor risk is an underperformance versus the equity asset class. This would occur in the event of a significant rise in the stock markets. As the primary motivation for an investment in the ‘aristocrats’ is the search for regular income, this is a minor risk.