Bond Proxies Turn Into Problem Children as Rate-Hike Fears Rise

(Bloomberg) -- In the years of rock-bottom interest rates, investors piled into a class of stock coveted for its consistent payouts. Now, as the Federal Reserve looks certain to raise rates at least three times this year, the group is trotted out as Exhibit A for why the nine-year bull market might be in danger.

Known as bond proxies, they’re the companies that peddle soap, diapers and ready-to-eat food. While they lack the heady price returns notched by high-flying tech and bank shares, they’ve been stalwart in the ability to return cash to investors. Consumer staples, phone and utility companies have the highest dividend yields, a measure of a stock’s price relative to its payout.

But those rates for S&P 500 companies are shrinking relative to that of Treasuries and now sit at the lowest level since 2008. Fed Chairman Jerome Powell’s testimony Tuesday did little to alleviate concerns that short-term bond rates will push ever higher. The yield on two-year Treasury notes now tops 2.3 percent, the highest in almost a decade, and exceeds the 1.9 percent dividend yield offered by U.S. shares.

“For the first time in three years, bonds are starting to look really exciting relative to equities,” Mark Kiesel, Pimco’s chief investment officer of global credit, said in an interview with Bloomberg TV on Feb. 21. “You can get an almost equity-like return in a higher-quality portfolio with a third the volatility.”

Fund flows show investors have taken notice. So far this month, more than $1 billion was pulled from U.S. exchange-traded funds tracking companies with high dividend payouts, on pace for the biggest monthly outflow since early 2016 -- right after the Federal Reserve hiked interest rates for the first time in almost a decade.

Flows are following diminished performance: The S&P 500 Dividend Aristocrats index dropped 3.8 percent in February, on track for the biggest monthly loss since October 2016, compared to a 2.6 percent retreat for the S&P 500.

Bond surrogates may see their dividend yields continue to shrink relative to the two-year rate as the Fed presses ahead with hikes. Companies have largely tapped the debt markets to fuel dividend increases -- leverage among dividend companies in Europe has ballooned, and U.S. firms have seen leverage triple compared to the rest of the market, according to analysis from Deutsche Bank AG.

“This policy is not sustainable in the long term,” analysts at the bank, headed by Luke Templeman, wrote in a Wednesday note. “Indeed, since the bond yield nadir in 2016, high-dividend paying stocks have underperformed the market.”

Fixed-income surrogates now face two threats, according to Deutsche: investors switch to bonds while corporates struggle to refinance their debt loads. Relief, at least for U.S. companies, could come from the Republican tax cuts.

In the three years through 2017, the average yield on the dividend aristocrats index was 0.4 percentage points higher than 10-year yields, data compiled by Bloomberg show. Now, the stocks offer about 2.3 percent compared to almost 2.9 percent on the 10-year.

Bank of America Merill Lynch, for its part, told clients in a recent note to consider "avoiding both short-duration equites (bond proxies) and long-duration equities (secular growth stocks)" in order to hedge the impact of rising rates late in the U.S. business cycle.

©2018 Bloomberg L.P.

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