When interest rates and bond yields rise, and markets and economic direction take a turn for the worse, it tends to be the weakest elements in the economy – typically those companies with the greatest amount of debt – which suffer first. Yet corporate leverage is back where it was during its dot com and global financial crisis peaks. Should investors be worried?
What rising bond yields mean
Rising bond yields don’t automatically mean equity losses. They tend, initially at least, to be accompanied by a rally with both asset classes driven on by improved economic conditions. Only in the later stages of the cycle do they have a negative impact. The last time there was a switch from a positive to negative correlation between equities and bond yields (1960s/1970s), it coincided with bond yields pushing past the 5% barrier. We’re a way off that, so investors should still have a decent cushion before rates become a problem – but stretched valuations in some parts of the world mean a little caution is merited.
Correlation between S&P500 and 10-yr treasury yields since 1900
Source: Lyxor AM International, Shiller. Rolling 5-year period, monthly data as at 01/05/2018. Past performance is not a reliable indicator of future returns.
In our view, global economic conditions are still improving (albeit more slowly), so your choice rests between switching out of bonds and into suitable equities or sitting tight until potentially you are forced to move. If you are going to hold bonds, you have to believe economic conditions won’t improve; deflation will set in and central banks will make ever more desperate attempts to drive yields lower.
Those wary of making seismic asset allocation changes may be tempted to switch from low quality bonds to high quality equities – a change which puts balance sheet strength before anything else. Finding them isn’t as simple as it might be however.
Not buying buybacks
Many companies have tried to exploit the low yield environment by re-leveraging in order to grow but changing conditions leave some more exposed than others. Tech companies aren’t significantly at risk because their balance sheets are often cash rich but the same can’t be said elsewhere, especially where companies have engaged in massive stock buybacks – something which, in our view, destroys shareholder value more often than not. Over time, those companies tend to be the weakest and cheapest (relative to their peers) in the market. Their price momentum is weak and they generally have ‘below average strength’ balance sheets. Selling this balance sheet risk, and focusing on companies with shrinking debt and improving fundamentals, makes sense at a time like this.
Replacing or augmenting mainstream equity allocations with equivalent Quality Income (QI) strategies which value balance sheet strength above all else could be the solution. True, the kinds of stable businesses these strategies hold haven’t necessarily enjoyed the irrational exuberance that’s driven markets so much higher in recent years. But they might be a better bet for what comes next…
Why balance sheet strength matters
The nature of these businesses means their earnings are predictable, rather than cyclical, so they are rarely seen as fashionable. In fact, QI stocks’ main source of relative performance is the drawdown protection they offer when markets are stressed. Handily, they also offer another way of countering rising inflation – dividends tend to track inflation higher, unlike fixed rate securities.
Over the long term, QI equities have delivered similar returns to high yield credit. Drawdown too is similar but the overall risk/return profile is better; with higher return and lower volatility for QI equities.
Maximum drawdown/loss on global assets since 1990 (%)
Past performance is not indicative of future performance. Portfolio presented assumes no transaction costs. Source: SG Cross Asset Research/ Equity Quant, Factset, data as at 31/12/2017.
Volatility-adjusted returns since 1990
Past performance is not indicative of future performance. Portfolio presented assumes no transaction costs. Source: SG Cross Asset Research/ Equity Quant, Factset, data as at 31/12/2017.
Where you can find “good” balance sheets
Despite being close to its 20-year average, US leverage is far higher than we saw in the run-up to the 2008-09 crisis. In Europe, levels are even higher. Interest coverage in both regions is weaker than it was, despite recovering global earnings and artificially low yields.
Leverage ratios suggest most eurozone country indices are in line with long-term averages, but this is not true of the US or UK. We still find the most leveraged companies in Spain and Italy but France, is now less geared than the US or UK equity markets. Interest coverage ratios show significant improvements in France and Germany (excluding financials) since 2017, but it’s different on the periphery. Spain’s coverage has improved, but is no better than it was prior to the 2008-09 financial crisis; Italian companies have yet to improve their solvency at all. In fact, the opposite is true despite the supportive environment.
At the sector level, Utilities and Telecoms are more highly levered when compared to other sectors and their own long-term averages. For all that, there are still good companies to be found in these sectors and they remain pivotal to our portfolios. We’re confident our methodology weeds out those that aren’t quite so strong.
An example of how quality income indices are constructed: SG Global Quality Income
Why Lyxor for quality income?
Our five quality income generators aim to target the most robust and stable businesses in the developed world. We range across broad global markets, as well as strategies specific to Europe, Japan, the UK and US – with TERs starting from just 0.19%, making them some of the most cost effective income generators your money can buy.
Find out more at www.lyxoretf.com
All views & opinion, Lyxor Equity & SG Cross Asset Research/ Equity Quant team, as at 15 May 2018 unless otherwise stated. Past performance is no guide to future returns
