A recurring theme in the news recently has been the global bond market sell-off and its impact on defensive shares, specifically those being branded as “bond proxies”.
There’s a good article on this subject on the Woodford Investment Management blog. In short, their conclusion was that a prolonged bond sell-off was unlikely in the short-term, but that “Credit markets are in dangerous valuation territory where capital losses ultimately look inevitable in the long-term.”
I’m not going to argue with Neil Woodford’s team; no doubt they are all immeasurably more intelligent and better informed than I am. What I will do though is take their basic proposition, that a major bond sell-off or bear market is virtually inevitable in the long-run, and use that to investigate the risk that some defensive sectors may not be as defensive as some investors think.
Why would a bond market sell-off affect defensive sectors?
This is a gross simplification, but the yields on income producing asset classes, such as bonds, equities, cash, property and so on, are all connected.
For example, if high inflation returns, then cash accounts can be expected to increase their yields. If cash yields increase then bond yields are also likely to increase. This wave of increasing yields would then (in theory) move onto other income producing assets, including equities.
So if bond yields increase (i.e. bond valuations fall), yields will increase for equities, which means lower share prices.
This could particularly affect defensive sector shares and bond proxies because many bond investors are thought to have moved into low risk, dividend paying shares as the yield on bonds was simply too low for them.
In summary then, if bond markets fall then defensive shares and bond proxies are likely to fall with them.
Dividend yields as an indicator of risk
If bond yields are the driver of risk for defensive shares, then I think a reasonable approach to measuring risk in the various defensive sectors is to use dividend yield.
For simplicity’s sake, I’ll just say that a defensive sector is more at risk from a bond market sell-off if it has a low average dividend yield and vice versa.
The table below shows the dividend yields, and some other factors, for all defensive sectors. Note that these are the Industry Classification Benchmark (ICB) sectors, as used by FTSE.
First, a couple of notes: 1) PE10, Growth Rate and ROCE (ROE for insurance companies) are all based on 10 years of data. 2) These figures only include companies that have a 10-year unbroken record of dividend payments.
Health Care and Personal Goods could be most at risk
As the table above shows, Health Care Equipment & Services and Personal Goods are the two defensive sectors that, because of their low dividend yields, could be most at risk when the bear market in bonds really gets going.
That’s not a complete surprise as those two sectors are often cited when people talk about bond proxies.
Both sectors are truly defensive, with neither being particularly sensitive to the ups and downs of the economy. They also contain companies with high historic growth rates, and so the average growth rate for those sectors is above both the market average and the average for defensive sectors in general.
Because of this combination of low risk and high growth characteristics, it is entirely reasonable that those two sectors – and their underlying shares – are more expensive and lower yielding than higher risk, lower growth sectors.
However, even if their low yields can be justified in the long-term by high growth rates, that fact is unlikely to provide them with much downside protection in the short-term if the bond market collapses.
Utilities, Tobacco and Fixed Line Telecomms could be the safest place to hide in a bond bear market
At the other end of the valuation scale, we have some of the least “sexy” sectors. While the utilities seem to have grown slowly overall, which is as I’d expect, Tobacco and Fixed Line Telecomms may not deserve their low valuations and high yields, at least going by their past profitability and growth rates.
From a valuation point of view, if the bond market fell, the already high dividend yields in these sectors could provide some much-needed support to their share prices.
Defensives are only truly defensive when their valuations are defensive as well
A defensive company and a defensive investment are not always the same thing.
A defensive company on a high valuation and with a low dividend yield could easily see its share price fall, even if the underlying company continues to grow.
To be truly defensive, an investment must combine both a defensive asset (company/bond/property etc.) and a defensive valuation, which is a fact some bond investors and bond-proxy investors may have forgotten (and some property investors as well).
UPDATE: You can read part 2 of this article here.
Note: In this article I’ve focused on sectors which might be at risk due to their low dividend yields, which could increase (i.e. their share prices could fall) if bond yields increase. Another impact of increasing bond market yields could be that highly indebted companies struggle to refinance their debts on favourable terms. Also, if bond yields rise due to rising inflation then, as fund manager Nick Train has said, history “teaches that the type of companies that suffer most operational damage during periods of rising inflation are capital intensive suppliers of commodity products”. I’ll take a look at each of those issues in a follow-on article.