Equities that behave like bonds remain interesting investments - even in a higher-for-longer interest-rate environment. If interest rates start dropping, their popularity could soar.
Is there a relationship between interest rates and equities? Yes - and it's close and important. Lower interest rates make it cheaper for companies to borrow money. They also encourage consumer spending, and have the potential to raise asset values. When rates are high, they push up the discount rate thus shrinking the present value of companies' future cash flows. So whether rates are low or high, they affect corporate profitability and thus share values.
Last year's rate rises - the strongest in half a century - boosted company borrowing costs and clobbered equity valuations. Cyclical stocks and fast-growing enterprises in capital-intensive industries were hit particularly hard. But defensive stocks in more stable sectors suffered too, as bond yields outpaced dividends.
Almost all the talk so far this year has been of interest rate cuts, but we are still waiting for regulators to act. While monetary policy paths appear to be diverging, with inflation reportedly closer to target in Europe than in the US, neither the European Central Bank nor the US Federal Reserve seems keen to make the first move.
The ECB kept its deposit rate at four per cent after its April meeting. In Washington, with a nod to the strength of the US labour market, Fed Chair Jerome Powell suggested that the US central bank may need to keep rates higher for longer to achieve its two per cent inflation target.
So where does all this leave bond proxies, or equities whose regular dividend payments provide a steady income stream (similar to interest payments on bonds)? "When interest rates finally do go down, these stocks may present a good investment opportunity," observes Chris Burger, Senior Equity Analyst with LGT Private Banking. Bond proxies may hold appear in the interim as well. Here's why.
Bond proxies are less vulnerable to market volatility
Though to be sure, any equity investments is linked to typical risks, bond proxies are essentially defensive stocks with a low beta, which is a measure of the volatility (or risk) of a stock relative to the market as a whole. This means that the price performance of these bond proxy stocks correlates less strongly with the overall market, and makes them, like bonds, less vulnerable to market volatility.
Such equities are typically found in sectors like consumer staples, utilities, pharmaceuticals, the telecommunications sector, and to some extent, real estate. These are defensive sectors that include businesses providing basic consumer needs that can generate relatively stable profits, even during economic downturns. Bond proxies are also usually the stocks of mature companies with stable cash flows, which further reduces their vulnerability to economic cycles and volatile markets.
The regular dividends that bond proxies pay shareholders enhance their similarity to bonds. But these dividends become much less attractive than rising bond yields when interest rates rise, as they did in 2023. Indeed, bond proxies' fortunes seem especially impacted by the behaviour of interest rates. LGT analysis of the relative performance of the food industry since 2000 clearly shows this particular defensive sector's exceptionally close correlation with the level of interest rates: when interest rates fell, food shares outperformed the market as a whole; but when rates rose, these shares underperformed.
Attractive entry opportunities for safety-oriented investors
Bond proxies are not necessarily for everyone. "If you're a growth investor, you don't really go for them," says Burger. But for yield- and safety-oriented players who want to perform in line with the market and receive a high dividend, their appeal is clear.
Even in today's higher-for-longer interest-rate environment, "with the valuation contraction largely complete," they offer what Burger calls "potential attractive entry opportunities." To be sure, as stocks, bond proxies carry the same risk of losses as any other equity investment.
Bond proxies are in favour when market participants anticipate a recession and monetary easing.
As long as interest rates do not rise further, the current pressure on bond proxies should begin to lessen. Their positive earnings potential underpins their appeal as investments. And in an environment of falling interest rates, the expectation of stable earnings growth opens up re-rating potential.
Furthermore, as the spectre of inflation recedes, share prices, which discount future cash flows, re-rate upward, an effect that should be amplified in bond proxies. And as Burger suggests, "If the economic outlook continues to deteriorate, bond proxy valuations could even get a tailwind from declining interest rates."
Bond proxies will benefit from easing of monetary policy
Chris Burger, Senior Equity Analyst LGT
Bond proxies are in favour whenever market participants anticipate recession and monetary policy easing. Despite central banks' current hesitancy, most observers expect monetary policy to ease later this year. Indeed, LGT economists anticipate accumulated rate cuts of 50 to 75 basis points from the Fed and 75 to 100 basis points from the ECB over the course of 2024.
Meanwhile, for more defensive players, bond proxies can offer important advantages. They may be shunned by bond investors and overlooked by equity fund managers whose main concern is earnings growth and - as with any equity investment - carry financial market risk. But as Burger points out, in an inflationary environment, as "real" assets they offer better protection than bonds. What's more, as a relatively heterogeneous group, they are also well diversified.
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