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.
Great article, John.
This has been something I have been thinking about a lot recently. I did miss Woodford’s article though, it must be said. You’re absolutely right that defensive companies are only defensive when they are defensively priced. The likes of SABMiller and Reckitt Benckiser, for example, look to me to be a bit too expensive to be defensively priced despite their clear defensive characteristics.
As you may remember, I have been looking to bulk up my beverage holdings recently. However, despite the attractions of SABMiller I have headed to smaller caps like Britvic and, most recently, Stock Spirits. Maybe less defensive in many regards, but certainly their valuations look more appealing (read defensive!) in the current environment. We will have to see how they react once interest rates and bond yields start rising!
We live in interesting times! Thanks again for writing this up for us. Very interesting.
Hi DD, you’re welcome. I guess it’s like the old adage that growth and value are two sides of the same coin, where in this case “defensive” means “reliable growth”.
Britvic comes up fairly high on my screen, and realistically I think it’s looking nicely priced with a 3% yield and near 10% annual growth for many years. Whether that will continue is another matter, but then again I could say that about any company…
I do not see this as a main worry.
The article starts with a supposition – that interest rates are to go up significantly – bond sell off.
Bond yields have gone up and down in the last two years and they will move again one way or another however I do not think a bond sell off is likely to happen and I took the contrarian view of buying Governmental bonds after the yields improved this year. It is worth noted that at 1.5% per annum my prognosis for Global inflation for the next year, 15 years bonds offer a 1.5% per annum real return, which is close to its real return average of 2% per annum. Even if the bonds yields move another 0.5% per annum up, that will not mean a bond sell off.
However if there is a bond sell off, there will be very few places to hide, probably Japanese equity will react diferrent, but the correlation with Global equity will be high. Bank stocks may also react diferently if the yield curve steepens, as they can in theory make larger profits.
I will not ve so concern on stalwarts, but on value stocks. These companies need to borrow and their sales will be affected by going down.
I do not have a great view on tobacco and utilities. Tobacco big cycle has gone, I invested in 2000 when they were dirty cheap, now I sold nearly everything apart from a small holding in Japan Tobacco, Swedish Match (which I increased yesterday) and Lorylland Inc (US) which I bought after their aquisition of the UK SKYCIG. I can see a trend in these niches, but not in the mainatream market.
And utilities, they have too much debt to carry (and cost to service will increase with a sell off), too much regulation and too much burden to invest to become “clean” or “green”. This is capital intensive, but you will write about this. Some telecom, yes, but not too much fixed, more mobile where there is a frenzy on M&A from which money could be made.
Now probably is the time to create those media integrated companies, that fell 10-15 years ago. There is now enough content (video on demand, games etc) to be sold and better infrastructure for high speed internet, which was not available 10-15 years ago. I already have Mediaset, BT, BSkyB in my portfolio, a Chinese company and a Japanese one.
I still keep my Google, Apple, Microsoft, Samsung, Amazon investments and a bit of Facebook shares for the time being. For me these are the “utilities of the future”.
We shalk not forgot the banks, I started investing last year in US banks, and just booked a few British as well (Barclays last month and Lloyds yesterday). The banks will be so regulated, they will also be the utility of the future.
Too many utilities, isn’t it?
Hi Eugen, insightful as always. As you say, I’ll cover the point on debt and capital intensity in the second article as they’re important points.
As for your “utilities of the future”, I like that analogy. I’m not so sure about Apple as I have never owned an Apple product in my life; but then again my wife never uses Google (for some reason she likes Yahoo!) so each to their own, but I definitely agree with your sentiment.
I would say the weakest of that bunch is Facebook, although perhaps I would say that because I don’t use it. I just look at what happened to MySpace and I think the same could happen to Facebook if the next generation of kids don’t want to use the social network used by “old” people (i.e. those over 20).
It is true that Facebook has many chalenges ahead, but it could also brings many, many opportunities. As a result, it is worth a little gamble, just a little. It is expensive on all metrics, but you never know.
The good thing is that Facebook has a clientelle which its disposable income increases every day, they finish schools, universities, get into work, they improve. Best, their parents and grand-parents join them on Facebook too, bringing their higher disposable income with them, I love this even more.
I use Facebook for both pleasure and business. It alows me to learn more about my clients, what do they stand for, and allows them to learn more about me. It creates relations based on real trust.
To give you another example, I needed some help with some plumming work. My wife went onto youtube and starting watching what needs to be done. Myself I put the request on Facebook and in two hours I had 17 relevant answers, out of about 50 people who came back to me.
And with Apple: I bought recently the Apple TV box which allows me to connect all my iPods, iPads, iPhones and Apple laptop to my tv. It works a beauty. I am looking forward to buy the Watch. Hopefully they will invent a proper SLR camera one day with 4G, Wifi and Bluetooth connection to take Cannon or Nikkon out of business. All I need it to do is to save my pics in the Cloud automatically and be able to publish on Facebook in less than 20 seconds, nothing more.
I suggest you try to apply your metrics to the Apple stock and you will be amazed how cheap it is.
Regarding utilities: even the company which made the best whip went under when people switched to cars from horses. In many metrics they would have looked good investments.
Sorry to divagate a bit from metrics and numbers. Sometimes business are not only about numbers, but what they stand for and how their clientelle looks like and how it is going to satisfy its clients future needs and aspirations.
There is a book somewhere ‘Start with why’, which is worth reading.
Hi Eugen, I haven’t read the “start with why” book, but I’ve read a summary and I agree that in consumer-facing products it’s a good strategy. As for Apple as a stock, I have been meaning to put its numbers into my stock screen to see how it does. When I do I’ll write a blog post on it.
Couldn’t agree more with Eugen
Hi Lelsy, it looks like I have the weight of opinion against me on this one. Oh well. As Ben Graham said “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Although in this context “right” simply means that I do not like large pension schemes, RR has one, and so it is not for me at this point in time. Perhaps we can look back five or ten years from now with perfect hindsight to see how things panned out.
Thanks for sharing John