“Bond markets” – these words send shudders through most investors’ brains. Bond-market specialists are a breed apart: experts in something dry, mysterious and complex. Most private investors prefer not to go near them. Even professional investors become too wrapped up in their own markets to spare bonds more than a passing thought. But that’s a serious mistake. The bond market runs everything. Its workings may be obscure, but its movements determine everything that happens in other markets. The bond market is the pied piper, the rest of the world’s markets are merely the rats. And right now, with markets in turmoil, it’s a crucial time to check what tune the piper is playing.
Bond markets: indicators of future trends
And bond markets – particularly the big daddy of them all, the US Treasury 10-year bond – are also good indicators of future trends. So forget chicken entrails, tea leaves and astrology charts: let’s grab some of those reams
of bond-market numbers and start soothsaying.
The most important thing to bear in mind is the idea of relativity. Right now, you’re travelling at over 1,000 miles an hour as the world spins, but it doesn’t feel like it. The reason it doesn’t feel like it is that the ground, your house – even the air around you – is also travelling at the same speed. You only perceive actual speed when you move relative to the things around you – for example, when you drive your car. In a very crude sense, this is the basis of Einstein’s general theory of relativity and applies to just about everything we are more used to thinking about in terms of absolutes.
Relativity also applies to finance. It’s pretty meaningless to say a stock price rose £1 last year. This could have been a great performance if the stock started the year at 10p, but less exciting if it had already been trading at £10 the year before. Instead, we look at how much each stock moved in percentage terms. But that’s not the end of the story by any means. If a stock rose 10% but the rest of the market rose 20%, it would be a relatively poor performance. Yet if our 10% gain occurred during the dotcom crash, it’d look wonderful. On top of that, we’d still want to assess the relative risk we were taking, as well as a host of other factors – such as inflation and dividend yield – before we’d decide if we were happy or not with our 10% return.
At the end of the day, whether we’re comparing commodities, real estate, emerging-market debt or blue-chip equities, we need some way to compare these relative returns. In the same way that anyone except an astrophysicist judges their speed against the ground, all financial markets swing to the beat of one dominant drum: government bond yields.
Most individual investors don’t look at government bonds much. The bond market is so large that minimum dealing sizes dwarf individuals’ assets. Bond yields always seem a bit puny compared to the potential returns available from hotter, riskier asset classes. The markets don’t seem to move that much and are dominated by huge banks and massive professional funds.
Even the terms used seem designed to confuse outsiders: as with other assets, bond yields move inversely to prices, so falling bond prices mean rising bond yields. But unlike most markets – where people usually refer to price movements – yield changes are the standard way of talking about bond markets. Rarely do people say ‘bond prices rose’; instead, it’s ‘bond yields fell’. It all seems too arcane an arena for the man in the street.
But equity investors take their eye off bond yields at their peril. A single classic example proves this well. In February 1987, the US S&P Composite was on a prospective price to earnings (p/e) ratio of 14 times – not an expensive multiple historically. People expected earnings to grow about 10% year-on-year. Everything looked wonderful and over the next six months US stocks went up nearly 20%. By October 1987, things were even better. Earnings growth forecasts were up to 17% year-on-year. The p/e was still under 14 times. Then the 19 October crash wiped nearly 30% off the value of US equities in just four days. The surprise was absolute.
How could this happen? The p/e was still comparatively low and the earnings outlook buoyant. What was going on? Relativity. Although stocks’ circumstances were no worse in an absolute sense, their relative appeal compared to bonds had collapsed. Seemingly unnoticed by investors, bond yields had surged from 7.25% in early March to 10.25% by mid-October. Equities crashed in 1987 simply because they were no longer attractive relative to bonds.
With that lesson taken on board, let’s take a close look at conditions in the bond markets and see what they tell us about the risk of another crash. We have two big questions that need to be answered: are bond yields about to rise and what markets will be hit if they do?
Bond markets: US Treasury bond yields
Since the early 1980s, bond yields have been heading down. As the chart left shows, the yield on 10-year US Treasury bonds slumped from around 16% in 1982 to a low of almost 3% in 2002. Given that yields had been heading steadily up since the end of World War II, this was an enormous boon for the stockmarket. Suddenly, the returns on equities looked immensely attractive relative to bonds and stockmarkets soared as a result. The S&P averaged growth of 16% a year between 1982 and the millennium (despite the crash in 1987). This compares to just 2.8% a year over the 18-year period before 1982.
But bearish investors fear this golden age might have come to an end. As the chart shows, the 10-year US Treasury bond yield could be about to break out of its 25-year long downward trend. That, say the bears, could spell the end of this halcyon period of ever-higher equity valuations and thus the end of the great bull market.
Currently, it’s not absolutely certain yields will rise strongly. For now, the five-year moving average is still heading downwards. And if bond yields level off in the 3.5%-5.5% range that they’ve occupied for the last five years, this is still very low compared to history. But with US inflation rising – it’s now running at 3.5% – there’s good reason to think Treasury yields will have to climb further to offer a premium that will attract buyers. Add to this the giant game of chicken being played by the bond markets and the Federal Reserve, and it’s understandable why observant investors are feeling nervous.
The bond markets and the new Fed governor, Ben Bernanke, have locked themselves in a bout of ‘first to blink loses’, except in this game it’s us who could be the losers. Partly, US bond yields have been rising because bond investors are effectively saying to Bernanke: “we think you’re too soft on inflation”. They’re betting he’ll stop hiking short-term interest rates sooner rather than later to let the economy grow. That, the bond investors say, will let inflation accelerate, which means higher interest rates later.
The irony is that in order to prove them wrong, Bernanke would have to push short-term rates high enough now to slow the economy (which is already suffering from higher energy costs and a nascent housing correction) and make their bet (on a stronger economy and higher inflation) fail. Until bond investors are convinced inflation is not going to escalate, any further rally in commodities or weakening of the dollar (factors that contribute to higher inflation) will tend to drive bond yields higher.
So if bonds yields are going to rise, how much do they have to go before they start to make other assets look unattractive? Cast your mind back to 1987. Back then, bond yields rose about 300 basis points (3%) before equity investors made a wholesale scramble for the exits and piled into bonds. But a 300 basis-point rise then, when bond yields started above 7%, is a relatively smaller move than 300 basis points now, when Treasury yields started around 4%. We need to look at bond-yield moves in proportional terms. A look back at 1987 and other bond-driven crashes in the past suggests Treasury yields have had to rise about 50% in a year from their starting yield before they’ve triggered dramatic market turnarounds.
Treasuries haven’t risen that much yet, although there’s plenty of potential for them to go higher. But many long-term players are worried. The reason? There are already far too many high-risk assets that seem to offer far too little reward relative to Treasuries. These assets are obvious candidates for a beating if bond yields start to rise and many of them are now looking extremely vulnerable.
Bond markets: emerging-market and junk bonds
Take emerging-market bonds. These are intrinsically more risky than US government bonds as there’s a greater chance the issuing government will default. So investors should demand a much higher yield to compensate for the extra risk. But how much extra? History suggests quite a lot. For example, when markets last got worried about emerging markets during the Asian Crisis in 1997-1998, the spread (the difference between emerging-market bond yields and the Treasury yield) went up to eleven percentage points.
Today, the premium they command over Treasuries is virtually non-existent. On a long-term spread chart, with high spreads offering low risk and high reward and low spreads the opposite, spreads are super-low. Emerging market bond investors are getting no extra reward for taking on more risk – in other words, emerging markets have rarely, if ever, looked so expensive relative to Treasuries.
It’s a similar case with junk bonds, where there is at least still a small premium to be had. A junk bond is corporate debt that the ratings agencies, such as Standard & Poor’s, assess as being below investment grade. The spread here is about 300 basis points (3%) more than much-safer US government debt. Just three and a half years ago, investors needed 1,000 basis points (10%) higher yields to tempt them into taking on the higher default risk inherent in junk-bond debt. Gamblers wouldn’t stand for the casino lowering the payout at the roulette table and bond investors are the same. Government bond yields just need to rise to whatever level it is that makes investors satisfied and they will pull their funds away from higher-risk assets that aren’t offering a commensurately higher yield.
So emerging market debt is one asset class that looks exposed if bond yields rise. What are the others? Well, there’s one I think is severely overvalued (and I’m disagreeing with the broad consensus at MoneyWeek here) – commodities. This class is less easy to compare directly to bonds – there’s no yield that we can size up alongside US Treasury yields, for example. So we need to look at the broader economic picture in the US.
Bond markets: commodity prices and the US economy
For several years, the US has been driving much of the global economy. This may be about to end. Higher mortgage rates and the rise in gasoline and energy costs have contributed to a sharp double-digit drop in new home sales. Such falls have rarely occurred without a drop in GDP growth about one year down the line. Usually, it results in recession and this time it’s likely to be worse than usual because the US consumer is more stretched.
The chart below illustrates this by showing US personal outlays as a percentage of GDP (black line) with disposable income as a percentage of GDP rebased to it (red line). For over a decade, US consumers have been spending more than their incomes alone could support – but only because various assets, most recently houses, kept rising in value. These assets were all driven up by easy money and if houses are now no longer going to appreciate, then without some other price boom in an asset widely held by consumers, they are going to run out of spending power.
If the US economy is likely to see slower growth later this year, then it’ll prove harder to justify higher commodity prices, especially since there’s scant evidence of real-world demand driving commodities. Already there’s lots of evidence, for example, of rising inventories, few world supply shortages and, most recently, even substitution for cheaper alternatives going on. Rather, it seems commodity prices are primarily being driven by speculative funds, which are in turn also riding on the back of the easy-money tiger.
So commodity bulls should beware. If final demand is undermined by slower economic growth, a falling dollar and already high prices, higher bond yields could prove to be the final nail in the coffin of the commodity bull market. As Treasury yields rise, risky commodities will start to look less attractive relative to safer bonds. Once yields reach that crucial tipping point, all that hot money will flow back out of the commodities market. Nothing is entirely separate from the bond market and especially not the hot asset story of the day.
So where can you put your money that’s safe from the gathering storm of the bond market? It certainly makes sense to steer away from those areas that would be at risk from higher yields should the investment environment turn less benign. We’ve already seen that emerging-market bonds look exposed and high-yield corporate bonds not much less so. Commodities are running on momentum and fumes. Is there any safe ground?
Bond markets: dividend yields on equities
What about equities? This may sound surprising if you think back to 1987, when equities plummeted as bond yields rose. With market turmoil spreading across the globe over the last few weeks, some have already resuscitated the ghost of 1987 as a harbinger of doom for equities this time around. Anthony Bolton, star manager of Fidelity Special Situations Fund, said last Wednesday: “I think it could be the end of the bull market”.
But while it definitely looks like the end of the bull market for many assets, I don’t believe that UK blue-chip equities are facing serious trouble. Once again, the arguments are all about relativity. Take a look at the dividend yields on equities. Since companies tend to keep about half of all earnings to reinvest in future growth and pay out the other half of profits in the form of dividends, you’d expect UK stocks’ dividend yields to trade at about half of gilt yields. By and large they do. With gilts yielding around 4.5%, stocks should have dividend yields of half that, or 2.25%. Sure enough, that’s almost exactly the FTSE Mid Cap 250 Index’s dividend yield. So UK stocks currently look reasonably valued relative to bonds.
But there’s a discrepancy. The FTSE100 has a forward yield of around 3.25% (see the second chart on this page). That’s 45% over its historic level relative to gilts. It would appear that large-cap stocks are too cheap relative to bonds by a substantial margin.
They also look cheap compared to smaller stocks. The FTSE Mid Cap 250 Index usually trades at a 30% p/e valuation discount to the more liquid, more diversified and generally less risky FTSE 100 Index. However, today it’s the FTSE100 that trades at a valuation discount – of about 12%. For blue chips to close this gap on smaller stocks and gilts would take a relative rise of 45% -50%, giving huge potential for share gains.
To cap it all, the relationship between the FTSE100 dividend yield and the yield available from gilts has a very good track record of forecasting share-price moves in the past, as the third chart illustrates. When the dividend yield exceeds half the gilt yield, it’s a sign stocks are a buy; but when gilts return more than twice the FTSE100 dividend yield, it’s a clear warning to sell. With FTSE100 payouts at such highs relative to gilts, the bond market is telling us that high-yielding blue chips look like very solid buys.
Five top blue chips with great dividend yields
If you think that high-yielding blue chips look attractive, how should you go about picking some? You might imagine it’s a straightforward case of searching for the highest-yielding FTSE 100 stocks, but it’s worth bearing in mind that there’s another angle to investing for dividends. A successful company should be able to grow the dividend, so if you can get it on a high yield to start with, you could see an increase in the actual payout per share, plus an increase in the share price as its high yield starts to look more attractive. Here’s how to boost your chances of this:
Look at the payout ratio
If a company pays out a very high proportion of its profits as dividend, it may find it difficult to keep upping the dividend and even be forced to cut back in the future. Lloyds TSB is a case in point. The firm has so far managed to maintain the dividend contrary to pessimistic reports, but the share price has gone nowhere. This is because what was once one of the fastest-growing dividends in the banking sector hasn’t now seen any increase for four years. So although the forward yield of 7.5% looks attractive, a slightly lower yield with better growth potential would pay better over even a relatively short period of time.
It can be worth looking at some average-yield stocks purely because of the potential for raising the dividend-payout ratio. Take BP, for example. The forward yield of 3.7% is only half the return offered by Lloyds TSB or United Utilities and is nearly 1% less than gilts offer. However, there’s a really good chance that the dividend, which has grown four-fold in the last 20 years, will go up soon and possibly quite substantially. BP’s payout ratio has historically ranged between 33% and 65% of profits and it’s right at the bottom of that range now. Even without any further profit growth – unlikely for an oil major in this environment – a return to a 50% payout ratio would send the dividend yield to over 5%. Four times in the last quarter century BP has briefly had the same yield as gilts, but never has it yielded more. So if its yield rises to these levels, it could be a strong boost for the share price.
Check the historical dividend-growth rate
Consider Royal Bank of Scotland, which has an indicated yield of nearly 4.7%. This is comfortably above the return from gilts, if a little shy of Lloyds TSB’s yield. But unlike Lloyds TSB, dividends from RBS have risen more than 80% in the last four years. Strong dividend growth soon makes up for a slightly lower yield.
Beware of utilities
Growth rate is a reason to be demanding when buying utilities. They usually offer high yields, but often struggle to grow dividends fast. United Utilities pays the highest apparent yield in the FTSE 100 of 7.5%, but whereas it used to have a payout ratio of 30% in the early 1990s, it is 100% now. While the dividend has tripled, earnings haven’t grown, so the company has had to pay out more from profits. Now they’re paying out 100% of profits, it’s not clear where any future dividend growth could come from.
An exception to this rule is National Grid, which has an indicated yield of 4.8% and a strong dividend growth track record. The dividend has grown 65% since 2001, yet NG pays out no more as a proportion of profits now than it did five years ago. Unlike many electricity and water utilities, it’s a reasonable bet that NG can continue to grow dividends from here.
So the ideal combination of features for a high-yield stock is a dividend yield higher than gilt yields, with a good dividend-growth track record and a low payout ratio. This is usually too tough a list to be able to satisfy, but not today. These are exceptional times for yield-hungry equity investors looking to take advantage of the most attractive risk premiums to current Government bond yields that we’ve seen in a generation.
Five attractive high-yield blue chips
BT (BT/A) forward yield 5.8%
National Grid (NG/) 4.85%
Royal Bank of Scotland (RBS) 4.7%
Legal and General (LGEN) 4.6%
BP (BP/) 3.7%