1 FINDING YIELD Opportunities remain, but the evolving complexion of bond and equity markets demands a nuanced and cautious approach. Investment Ideas TARGET HIGHER-RATED CREDIT Higher-rated high-yield credit sectors offer more attractive compensation for prevailing risks. DON T DISMISS EMERGING MARKET DEBT Long-term case remains attractive with better yield relative to other fixed income sectors. SEEK YIELD SUSTAINABILITY IN EQUITIES Look beyond traditional defensive sectors to Resources, Telecoms, and IT.
WHERE NEXT FOR YIELD? Almost a decade after the global financial crisis, investors continue to contend with slow global economic growth. Unprecedented intervention in financial markets by monetary authorities, seeking to bolster fragile economies, has had a deeply depressing effect on yields. As we extend into the latter stages of the economic cycle, this backdrop of diminished yields looks set to continue. Where does this leave investors eager to fulfill the income objectives of their investment strategy? The search for yield over recent years has drawn many to high-yield bonds alongside dividend equity-focused strategies. But as the complexion of markets continues to evolve, we consider how, in 217, the quest for yield is even more nuanced. FIXED INCOME Credit markets have proven a popular recourse for yield in the fixed income sector. In the US, the relative strength of the economy has made the perceived risk/ return offered by US corporate bonds particularly attractive. Over the last two years, there has been a steady and consistent flow of foreign buyers of US corporate bonds. The trend has been supported by lower expectations for improvement in the global economy, reducing the probability of a rise in sovereign debt rates. Although yields on the corporate market are near recent lows, in comparison to the government bond market (see chart below) the additional spread, or yield over comparable duration treasuries, has proven to be more attractive. In particular, the lower-rated parts of both indices, namely credits rated BBB in investment grade and CCCs in high yield, have provided better returns from both yield and price appreciation. Yield to Worst* 25 Percent Barclays US Corporate Investment Grade Index Barclays US Corporate High Yield Index 2 15 1 5 1999 21 23 25 27 29 211 213 215 Source: Barclays. SSGA. As of 31 October 216. The Barclays US Corporate Investment Grade Index measures the investment-grade, fixed-rate, taxable corporate bond market. The Barclays US Corporate High Yield Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. * Yield to Worst (YTW) is the lowest yield an investor can expect when investing in a callable bond.
Valuations Too Low? Given how late we are in the credit cycle, has the search for yield driven valuations too low? Is it still prudent for yield-seeking investors to focus on the corporate bond market? The short response, for the first half of 217, is yes. A prime motivator for this is our expectation of continued lackluster growth (albeit enough to allow the US Federal Reserve to hike rates). The caveat: emphasis should be on the higher credit quality segment of the high-yield market, rather than further down the credit spectrum. Chuck Moon, Global Head of High Yield A careful eye toward developments in energy- and commodity-related sectors is also warranted, given recent volatility. Caution Credit Risk Rising The obvious attraction of corporate bonds is the additional yield offered relative to other fixed income instruments. Theoretically, higher risk premiums compensate for various risks credit being dominant in the case of high-yield bonds and actual default being the greatest risk. Although we believe that focusing on total returns is the correct way to manage corporate portfolios, we recognize that yield is a primary driver for some investors. Even then, however, the yield derived can be severely eroded from defaults possibly resulting in permanent loss of principal or coupon payments. Defaults are highly cyclical, with large variations over a business cycle. Defaults also vary greatly by ratings, with lower-rated credit defaulting at a much higher rate than higher-rated credit, even within the high-yield universe. The chart above right shows credit losses by the lowerrated sectors over time. Credit loss is a function of a default and the recovery rate after a default. *The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. The Importance of Credit An investor reviewing the Option-Adjusted Spreads* (OAS) of the lower-rated sectors to those of earlier years could be tempted by the relatively higher spreads that CCC-rated bonds now offer. However, defaults have moved significantly higher in 216. Historical Credit Losses 25 Percent 2 15 1 5 Defaults are rising 2 22 24 26 28 21 212 214 216 Ba B Caa-C Source: Moody s. Credit ratings are a simple system of gradation by which future relative creditworthiness of securities may be gauged. Adjusting for credit losses gives even more insight. In the chart below we look at the OAS levels at 31 December of each year and deduct the credit losses incurred the following year. For the current levels, we assume the OAS levels as of 3 September 216 and that credit losses decline over the next year by 2% from the levels reached by that date. OAS Less Credit Losses 12 1 8 6 4 Basis Points BB B CCC 2 Next 12 Months -2-4 2 22 24 26 28 21 212 214 216 Source: SSGA. On this basis, CCC-rated bonds offer little above the potential credit losses and would require defaults to decline substantially in order to prove attractive. In this environment, higher-rated high-yield credit sectors offer more attractive compensation for the risk of credit losses at current levels. This also provides some cushion if rates were to rise further than anticipated.
EMERGING MARKET DEBT Emerging market debt (EMD) recovered strongly in 216 as concerns around emerging markets, and China in particular, abated. But with the US presidential election signaling a sell-off in developed market government bonds and a risk-off attitude toward emerging markets, what does the future hold for EMD? Bond Yields in Emerging Markets 14 Percent 12 1 8 6 4 2 Hard Currency EMD Local Currency EMD 25 27 29 211 213 215 Source: SSGA, JP Morgan EMBI Global Diversified Index for Hard currency EMD. This tracks total returns for US dollar denominated debt instruments issued by emerging markets sovereign and quasi-sovereign entities. JP Morgan GBI-EM Global Diversified for Local Currency EMD. This is an emerging market debt benchmark that track local currency bonds issued by Emerging Market governments. It is not possible to invest in an index. The EMD universe has expanded steadily over the last number of years, especially in the local currency (LC) space, becoming a large and diverse universe. This increasing breadth and depth has enhanced liquidity and increased the accessibility of the sector. At the same time, active managers have underperformed consistently. What is particularly fascinating is the fact that underperformance is not the result of a single bad year or a Black Swan event. Instead, they have consistently failed to navigate one-off credit events, such as the Russia/Ukraine and Brazil sell-offs in recent years. Does EMD Exposure Make Sense? The case for a passive exposure to EMD LC then is compelling but what is the case for EMD LC as an exposure per se? We contend that the long-term case is attractive, centered on the attractive yield relative to other fixed income sectors (see chart left). EMD LC has traditionally been a volatile asset class, and this volatility is driven primarily by currency fluctuations. The chart below shows how EMD currencies have weakened steadily over the last number of years. EMD Local Currency Trends 12 Level JP Morgan Emerging Market Currency Index 11 1 9 8 7 6 26 28 21 212 214 216 Source: SSGA, Bloomberg, JP Morgan as of 16 November 216 Following the sell-off in recent years, EMD currencies provide a more attractive entry point for long-term investors. The short term will likely see more volatility as US Treasury yields rise and the dollar strengthens but, as this market matures, we expect to see increased allocations from investors. With political risk on the rise in developed markets, the case for a narrowing of the political risk premium between developed and emerging markets in the long term is persuasive. According to Morningstar, the 3 largest active EMD LC fund managers tracking the flagship index JPM GBI-EM Global Diversified Index have significantly underperformed their benchmark. Percentage of Underperforming Managers Average Annualized Manager Underperformance 1 Year 3 Years 5 Years 87 % 87 % 9 % -1.74 % -1.17 % -1.14 % Source: SSGA, Morningstar as of 3 September 216. Data based on the 3 largest funds in the Morningstar database having the JPM GBI-EM Global Diversified as their primary benchmark. Past performance does not guarantee future results. It is not possible to invest in an index.
EQUITIES Valuation and Dividend Profiles The equity market rally witnessed over the past six or seven years has been characterized by an unusual pattern of sector leadership. Stocks traditionally considered low-beta, and hence more defensive have, thus far, led the rally. This is particularly true of long-duration sectors where cash flows are more bankable, dividend yield pay-outs high, and the risk of a cyclical drawdown in earnings low. The Consumer Staples, Utilities, and Health Care sectors very much fit this profile. Valuations in these sectors have, consequently, become extended. On the other hand, more economically sensitive sectors have registered less emphatic shareholder returns and market ratings. The chart below illustrates this point by charting the historic valuations of high-dividendyielding stocks within US Consumer Staples, the US Information Technology and US Financial sectors. Clearly we are witnessing the greatest disparity in valuations between US Consumer Staples and moreeconomically sensitive sectors than we have seen for 2 years. In fact, the Price/Cash-Earnings multiple of US Consumer Staples has just reached 26 times or a sub-4% cash-earnings yield a paltry implied return from risk assets, by any measure. Valuations of this sort were last seen in 1998. The market ratings of the Financial and Technology sectors, on the other hand, are much more modest, and well below their 2-year averages. From a value investing standpoint, unusually, there appears to be more margin of safety in less-defensive sectors. Historic P/E Rating of Highest-Yielding Stocks 45 Price/Cash Earnings US Consumer Staples US Financials 35 US Technology 25 15 Shifting Dividend Payout Profile There has also been a significant shift in the dividend payout profile across global sectors in recent years. The dividend contributions from traditionally more defensive sectors such as Telecoms and Consumer Staples have been on the wane, whilst more cyclical sectors such as Information Technology, Consumer Discretionary, and Energy have seen their contribution to total market yield rise. This point is evident in the chart below, which ranks dividend yield in each sector in the Global Value Index relative to its 1-year median. The dividend yields on offer in those sectors are well above their 1-year median levels. These include Energy, Consumer Discretionary, Materials, and Technology. Those on the left-hand-side are below their 1-year median levels, including Health Care, Utilities, and Consumer Staples. Again, this suggests a potentially richer seam of dividend yield in lower-cashflow duration sectors. MSCI World Value Index Dividend Yield by Global Sector 8. Dividend Yield (% 12-Month Trailing) 7. 6. 5. 4. 3. 2. 1. Health Care Utilities Telecoms Cons Staples Financials Source: SSGA, Factset. The sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. The MSCI World Value Index captures large and mid-cap securities exhibiting overall value style characteristics across 23 Developed Markets countries. Industrials Technology Materials Current Median 1-Year Cons Disc Energy 5 24 28 212 216 Source: CSFB Holt.
Dividend Sustainability The appearance of high dividends is not, however, necessarily indicative of actual delivery of yield, or indeed of dividend yield growth. Scrutiny of the sustainability of yield is important. For example, the high dividend yield seen in the Energy sector in the Global Sector Dividend Yield chart opposite is partly a result of depressed valuations. Sustainability is very much in question given the moribund nature of energy markets in the short term. Investors need to zero-in on earnings-to-dividend coverage ratios to assess sustainability of yield. Excessively cyclical sectors will carry some risk of a weakening in earnings power as the economic cycle progresses, with the attendant risk of a cut to dividend pay-out ratios. Where to Find Dividend Yield? We see more sustainable dividend yields in the Resources, Industrials, and Information Technology sectors. And there are big differences in yield potential across regions. The Asia Pacific and eurozone regions are currently presenting some of the more attractive yield opportunities. William Killeen, Portfolio Manager, Fundamental Equity Again, in these regions, valuations and yields in traditional defensive sectors are not compelling, so income investors must employ a more nuanced approach in their search for dividend yield. More heterogeneous sectors currently present interesting opportunities. Ultimately, investors must weigh the yield opportunities in shorter-duration stocks against the maturity of the current economic cycle. LOOK FOR DIVIDEND YIELD SUSTAINABILITY Evaluate two essential factors: 1 Fundamental strength of the business factors that serve to protect revenue and margins. While more cyclical stocks will likely see dividend ratios flex with the economic cycle, idiosyncratic company fundamentals such as market share, scale, brand power, cost leadership, pricing power and barriers to entry can create a more predictable path for earnings. 2 Strength of the balance sheet the absence of significant financial leverage often allows a company to absorb earnings shocks without a significant cut to the dividend. Low leverage combined with a conservative dividend-earnings coverage ratio increases the potential for delivering a consistent yield through the cycle. The absence of leverage can often translate into a more equity-centric capital return ethos.
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