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A HIGH YIELD BOND ALTERNATIVE

Why dividend growth strategies offer a compelling alternative as monetary policy normalises

FOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

INVESTMENTINSIGHTS

March 2013

OUTLOOK & OPPORTUNITIES

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AUTHOR

Alex RobinsVice President, Client Portfolio ManagerGlobal Equities Team

The rebirth of equities

It can’t go on forever. Extreme monetary policy has to either end soon or be scaled down. This doesn’t mean interest rates will necessarily rise, at least not at first. However, once it becomes clear that ultra loose monetary policy is coming to an end, equities – the unloved asset class – will move, and move quickly.

It may sound premature to talk about an exit strategy for central banks, but if you believe the global economy is recovering this will mean that the countries where the recovery is most advanced will start to implement some sort of exit strategy soon. Judging by the recent fall in unemployment and the country’s abundant energy prospects, the US is likely to be first to initiate an exit strategy, followed by the UK and the rest of Europe.

The inevitable rise in interest rates will not be good news for bond investors. It will, however, be good news for equities. That’s because a rise in bond yields from unusually low levels reflects rising growth expectations and lower systemic risks.

IN BRIEFThis paper looks at the typical market reaction to an improvement in the economic backdrop, focusing on the likely outcome for different asset classes when central banks begin to unwind the extreme monetary policy actions that they’ve put in place over the last five years. We find four main conclusions:

• The flight to safety has left bond markets looking more precarious than ever, while equities have largely been left behind.

• Equities typically perform well in anticipation of an end to ultra loose monetary policy.

• Income seeking investors moving up the risk spectrum in search of attractively valued securities – from government bonds, to investment grade bonds, to high yield bonds, and now to equity income – will continue to be rewarded with a rising level of income and capital appreciation as the global economy improves.

• A defensive equity income product offers investors the chance to benefit from an improving economic recovery with strong downside protection.

2 | A high yield bond alternative

INVESTMENTINSIGHTS


It’s not a case of if, but when monetary policy will normalise

The timing, pace, and magnitude of future rate increases is critical to how these risks play out. If policymakers are able to manage a phased transition to higher rates, the potential bond bubble could deflate gently over time. A more sudden, severe rate increase would pose greater risks. However, a continuation of current policies may exacerbate financial market imbalances and the ultimate risks to investors.

Late last year the US Federal Reserve (Fed) said that the US short-term interest rate will remain near zero as long as the jobless rate stays above 6.5% (provided that projected inflation does not rise above 2.5%). Between September 2011 and December 2012, the unemployment rate dropped by 1.2 percentage points and now stands at 7.9%. Prior Fed communications about the likely exit strategy from accommodative monetary policy suggest that abundant liquidity will end when the unemployment rate is still somewhat higher than 6.5%.

Given the now-tight connection between the unemployment rate and the Fed’s next policy steps, the market and the Fed have displayed strikingly little reaction to the rapid fall in unemployment. On current Fed projections the unemployment rate is due to fall to 6.5% in 2015, implying the Fed will start to scale back asset purchases sometime soon.

EXHIBIT 1: US UNEMPLOYMENT RATE, % WITH END-YEAR PROJECTIONS FROM 2013 ONWARD

4

5

6

7

8

9

10

11

2010 2011 2012 2013 2014 2015 2016

%

Fed projections

Source: JP Morgan Securities Inc., Federal Reserve; data through January 2013 with FOMC projections as of December 2012

The flight to safety means equities have been left behind

The fallout from the Lehman crisis and the subsequent European Sovereign debt crisis has had equity investors running scared in recent years. Since 2007 equity outflows from mutual funds have totalled over USD 500 billion (see Exhibit 2).

EXHIBIT 2: THE WORLD IS LONG FIXED INCOME

- USD 562bn

USD 823bn

-600

-400

-200

0

200

400

600

800

Equities All bonds

2006 2007 2008 2009 2010 2011 2012 2013

USD billion

Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

It has been a very different picture for bond investors. Fixed income has enjoyed the types of returns you would normally associate from buying risk assets (see Exhibit 3A). Corporate bonds bubbled, yields fell and inflation-adjusted (index-linked) bond yields turned negative.

EXHIBIT 3A: THE PUSH AND PULL OF FIXED INCOME AND EQUITIES

Yield

0%

2%

4%

6%

8%

10%

12%

14%

16%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

US 10-year Treasury yield (constant maturity)

Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, Ibbotson

J.P. Morgan Asset Management | 3

EXHIBIT 3B: THE PUSH AND PULL OF FIXED INCOME AND EQUITIES

% return

-6%

-1%

4%

9%

14%

19%

1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

Large cap equity rolling 10-yr annualised monthly returns

Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, Ibbotson

The bond markets look precarious

• As interest rates have fallen, even safe fixed income investments have delivered very strong capital returns as well as providing investors with a good coupon. Bond prices have risen to such a large degree that a number of bonds are now trading at a significant premium to par value. Exhibit 4 shows that over 75% of the high yield corporate bond market is trading above par value with some bonds trading at a significant premium (in excess of 25%).

EXHIBIT 4: HIGH YIELD CORPORATE BONDS – PRICE DISPERSION BY PAR

0

5

10

15

20

25

30

35

40

Last month Current

% o

f com

pani

es

<70 70-75 75-80 80-85 85-90 90-95 95-100 100-105 105-110 >=110

Source: Bloomberg as at 31 January 2013

In an improving environment total returns for much of the credit market may not exceed coupon payments, as upward pressure on interest rates puts pressure on bond prices. Rates do not need to rise that much in order to erode a small coupon and the fear of such an outcome is already causing bond prices to fall.

Exhibit 5 shows the different loss scenarios for corporate bonds, given a 50-200 basis points (bps) rise in interest rates. If US interest rates were to revert to early 2009 levels (a 200 bps rise) a typical investment grade US corporate bond (BBB-rated with a ten-year maturity) could lose 15% of its market value, with a longer duration bond (30 years) suffering a 26% valuation loss in the same scenario.

EXHIBIT 5: BOND BUBBLE? INTEREST RATES TRUMP CREDIT

-30

-25

-20

-15

-10

-5

0

50 bps rate rise 10-year bonds

150 bps rate rise10-year bonds



Loss

% o

f Par

Source: Fitch Ratings, Bloomberg

In their thirst for yield, many investors are having to resort to poorer quality bonds issued by companies with unattractive balance sheets, just to achieve their yield objectives. Exhibit 6 shows the types of fixed income securities you are forced to invest in to achieve a 4.5% portfolio yield. One of the issuers that may have featured highly in a corporate bond portfolio offering such a yield is SEAT Pagine Gialle (a European retailer), which became the tenth company to default in 2013 after it missed an interest payment on its 2017 bonds. This is now the 84th company that has failed to refinance, missed cash payments or gone bankrupt in the last 12 months.

In contrast, to achieve a 4.5% level of dividend yield in a defensive equity income portfolio the stocks you will hold are very different. Typically the equity holdings will be in very robust global franchise names with strong balance sheets and that have safer and more sustainable cash flows.


INVESTMENTINSIGHTS


EXHIBIT 6: A HIGH QUALITY EQUITY PORTFOLIO WITH GROWTH . . .

Dividend fund — 4.5% yield Portfolio weightTime Warner +3.1

Merck & Co. +2.7

British American Tobacco +2.5

Pfizer +2.5

Royal Dutch Shell +2.5

Vodafone +2.3

Schneider Electric +2.2

Verizon +2.1

Australian & New Zealand +2.1

Wells Fargo +2.0

. . . VERSUS A LOW QUALITY BOND PORTFOLIO WITH NO GROWTH

Global Corporate Bond Fund — 4.4% yield Portfolio weightCharter Communications +1.1

NRG Energy +0.9

Goodyear Tire & Rubber +0.9

Ally Financial +0.9

AIG +0.9

SEAT Pagine Gialle +0.8

Bombardier +0.8

JMC Steel +0.8

Alliance One International +0.8

GXS Worldwide +0.8

As Fed tightening approaches we believe it is a good time for clients that are looking for attractive risk-adjusted total returns to consider bond-like equities as an alternative. Exhibit 7 shows the performance of equities in the anticipation of a tightening of monetary policy from extreme levels. A gradual benign rise in interest rates is typically a boon for equity markets.

Exhibit 7: Asset class performance in anticipation of Fed normalisationPerformance of equities vs bonds from 1960 to 1970

50

60

70

80

90

100

110

2%

4%

6%

8%

10%

12%

14%

16%

18%

'59 '60 '61 '62 '63 '64 '65 '66 '67 '68 '69

2-yr UST yield S&P 500 (rhs)

Gradual, benignrise in rates(+100bps in

3 years)

Boon forequities

Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg

Dividend funds seeing strong flows

Lower risk income-producing equities can offer investors an attractive investment opportunity, in particular those investors that are seeking attractive total return prospects with low potential drawdown and low levels of volatility. Exhibit 8 shows that the equity income category has already begun to see significant inflows, even as the broader equity market has struggled to attract capital.

EXHIBIT 8: DIVIDEND FUND FLOWS ARE PICKING UP

0

5,000

10,000

15,000

20,000

25,000

30,000

-1,000

-500

0

500

1,000

1,500

2,000

Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12

Monthly flows (lhs) Total net assets (rhs)

USD

mn USD m

n

Source: EPFR Global as at 31 December 2012

We believe investors moving from asset class to asset class and up the risk spectrum in search of excess returns over the last few years – from government bonds, to investment grade bonds, to high yield bonds, and now to equity income – will continue to be rewarded with a rising level of income and capital appreciation as the global economy improves.

Dividend growth companies are attractively valued

Within the equity income space we believe an attractive approach could be a strategy that focuses on companies with good dividend yields and the potential for dividend growth. This is for two reasons:

1. Above average dividend growth should reduce the risk of buying a stock whose dividends will be cut.

2. The combination of high yield and high dividend growth has, over time, produced better returns than a simple high yield style.


Recently, many investors have chased high dividend yields, and as a result these types of stocks have become expensive relative to history and relative to stocks offering high dividend growth potential. This trend underlies the recent outperformance of high dividend strategies versus strategies that seek attractive dividends supported by dividend growth.

However, valuations of stocks with a high current dividend yield are near their peaks relative to high dividend growth stocks (see Exhibit 9), so we believe we are entering the sweet spot for dividend growth strategies.

EXHIBIT 9: COMPANIES WITH HIGH DIVIDEND GROWTH ARE ATTRACTIVE ON A VALUATION BASIS

Price/Earnings (PE) of high dividend yield vs PE of high dividend growth

0.8

1.0

1.2

1.4

1.6

1.8

2.0

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

PE of high div growthvs PE of high div yield Average relative PEPE +1 STDPE -1 STD High dividend growth

stocks expensive

High dividend growth stocks cheap

Source: BofA Merrill Lynch Quantitative Strategy, as at 30 September 2012. For illustrative purposes only.

A good example of a dividend growth stock is Swedbank, which recently announced a dividend per share that was 50% ahead of market expectations. Swiss Re also announced a special dividend of CHF 4.00, on top of its common dividend of CHF 3.50. This takes Swiss Re’s total distribution to CHF 7.50 (representing a 10% dividend yield). These increases highlight that some companies (even in the banking sector in Europe) are generating strong levels of profitability and are returning excess cash back to shareholders in the form of dividends.

As we move further into 2013 we expect many more companies to announce strong dividend per share increases, indicating that balance sheets are in very good shape, companies are generating significant amounts of excess cash and they are now returning this to shareholders in the form of dividends.

Risk-reward outlook for dividend strategies is more attractive than high yield bonds

If clients are nervous about investing in equities, then it’s worth noting that the drawdown of defensive income equities is no worse than that of high yield bonds. Dividend strategies are much less volatile than other equity strategies, having lower downside capture than typical equity products.

Historically, dividend strategies have fallen significantly less than the broader market in periods when the market has fallen, while participating to a large extent in rising markets. Defensive equities with bond-like tendencies deliver sustainable income streams for investors and dividend cuts in these types of stocks are rare.

The impression many investors have is that high yield bonds, although a riskier choice within the fixed income market, represent a far safer investment than the equity market overall. Exhibit 10 suggests that this assumption is true, with the maximum peak-to-trough loss from holding global equities for a three-year period coming in at over 50%, while the loss is just over 30% for high yield bonds. But if we compare high yield bonds to equity income we see a different picture altogether. As Exhibit 10 shows, it is difficult to see much difference in the maximum drawdown between dividend strategies and high yield over the past 20 years.

EXHIBIT 10: HIGH YIELD BONDS ARE NOT A SAFER INVESTMENT

Maximum drawdown from holding global equities, dividend equities and high yield bonds

-60

-50

-40

-30

-20

-10

0

Dividend equities

ML high yield bonds

MSCI World Equity

Max

3-y

ear

draw

dow

n (%

)

Dec 92 Dec 96 Dec 00 Dec 04 Dec 08 Dec 12

Source: Société Générale as at December 2012. Dividend equities are companies with strong balance sheets, attractive dividends and high levels of excess cash. These companies are found in defensive sectors with betas of less than 1.


INVESTMENTINSIGHTS


The pricing power of equities acts an inflation hedge

Inflation has remained steady in the US and most developed countries. Deflation has failed to take hold despite low levels of economic activity and high unemployment. Now, easy monetary policies and the commitment of central banks to growth and to low unemployment have started to raise concern about the possibility of an acceleration in inflation.

In the Fed’s commitment to a 6.5% unemployment rate, there is a chance that some type of monetary policy mistake could potentially spur increases in inflation if the US central bank misjudges the degree of slack in the economy and maintains stimulative policy for too long.

EXHIBIT 11: IS EASY MONETARY POLICY STARTING TO PUSH UP INFLATION EXPECTATIONS?

Expected inflation rates

-3

-2

-1

0

1

2

3

0.0

0.5

1.0

1.5

2.0

2.5

3.0

May 07 May 08 May 09 May 10 May 11 May 12 May 13

US (lhs)

Japan (rhs)

Eurozone (lhs)

Source: Bloomberg, J.P. Morgan Asset Management. Last data 4 February 2013. Note: Ten year zero-coupon inflation swaps.

Equities offer dividend growth, which acts as an inflation hedge that is unavailable in almost all fixed income markets. However, the anticipation of the end to ultra loose monetary policy and the initial rises in bond yields may only be positive for equities so long as inflation expectations do not rise significantly. Exhibit 12 shows that the equity market does not start to de-rate significantly until inflation expectations increase to over 4%.

EXHIBIT 12: EQUITIES DO NOT TEND TO DERATE UNTIL INFLATION EXPECTATIONS RISE ABOVE 4%

10

11

12

13

14

15

16

17

18

19 Inflation range shown 12 m trailing P/E 12m fwd P/E

12m trailing P/E: 14.21

12m fwd P/E: 13.01

S&P

500

aver

age

P/E,

187

1 to

pre

sent

-3 to-2%

-2 to-1%

-1 to0%

0 to+1%

+1 to-2%

+2 to+3%

+3 to+4%

+4 to+5%

+5 to+6%

+6 orabove

Source: Dimson-Marsh-Staunton data, Credit Suisse research.

Dividend growth strategies outperform high yield bonds and other equity strategies

Over the longer term dividend growth strategies outperform high yield bonds and other equity strategies. If you had USD 10,000 invested in high yielding bonds in 1989 the value of your investment today would be a USD 67,107. And if you invested in high yielding equities the value of your investment would be USD 91.923. However, if you invested in high yielding equities with a strong dividend growth the value of the same initial investment would be USD 166,663, nearly 2.5 times more than the return from high yield bonds (see Exhibit 13).

EXHIBIT 13: DIVIDEND GROWTH STRATEGIES OUTPERFORM HIGH YIELD BOND AND OTHER EQUITY STRATEGIES

Performance of high dividend companies combined with high dividend growth versus high yield bonds

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

High and growing dividends

High yield bonds

High yield equities

USD 67,107

USD 166,663

USD 91,923

Source: Merrill Lynch High Yield Bond Index, MSCI, Worldscope, as at 31 January 2013.


Conclusion: How your clients can protect income portfolios as monetary policy normalises

After years of outflows, more recently equities have swung back into favour. Retail investors seem to be taking cash out of money market funds and reducing allocations to fixed income given the weaker value proposition and improving economic backdrop. There is significant risk of capital loss on fixed income investments as the central bank exit point approaches. Compared with bond alternatives, dividend growth stocks offer good risk-adjusted return potential and very attractive relative value. Cash generation has been exceptional over the past few years and there is now a very large amount of cash sitting on company balance sheets. A growing number of companies are already announcing healthy dividend increases.

EXHIBIT 14: EARLY SIGNS OF THE BEGINNING OF A ROTATION

Funds flows

-20

-15

-10

-5

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013

Bonds*

Money market

Developed market equities

USD

bn/m

onth

Source: EPFR, J.P. Morgan Asset Management. Last data 30 January 2013. Note, bond fund flows exclude high yield and emerging market debt. Flows include exchange traded funds.

As bond yields rise from unusually low levels we believe investment opportunities are the best in a generation in income-producing equities and a great prospect for investors in 2013.

INVESTMENTINSIGHTS


FOR PROFESSIONAL CLIENTS ONLY | NOT FOR RETAIL USE OR DISTRIBUTION.This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is no guarantee that any forecast made will come to pass.

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investment why dividend growth strategies ofler a insights … · 2015-11-01 · why dividend...

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