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The end of income investing — for now

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As interest rates declined and people found they could only renew their GICs at 2.5% or less, the search for high-income stock alternatives reached its peak, although the search for yield has been an investing battle cry for several years now.

You want 5% or 6% yields?  Here is what you get in Canada this year:

REITs: 6% yield; -11% total return YTD

Utilities: 6% yield; -8% total return YTD

Telecommunications: 5% yield; -1% total return YTD

REITs, telecoms and utilities since 2009 have been money in the bank. What happened?

Following 2008, when REITs were down 38%, they have annually returned 53% in 2009, followed by 22%, 21%, and 16% in 2012.

Utilities in 2009 returned 19%, followed by 18%, 6% and 4% last year. Strong returns for what are considered safe investments.

Another traditionally lower-volatility, higher-income sector has been telecommunications. In 2009, it was one of the worst performers (in a strong year) but still returned 8%. This was followed by 19%, 23% and 12% in 2012.

All three sectors are down this year. Is this just a temporary blip?

I believe there is a real change happening, and that the market shifts are not going to be positive for income investments for three main reasons.

The 3 strikes against income investing today

Strike 1: Some income investments are just too expensive today, while other sectors have been beaten down. Comparing Enbridge Inc. to Barrick Gold Corp. highlights this movement.

Enbridge is a fantastic business that made it through the 2008 crash better than any other TSX 60 stock.  The problem is that the stock is arguably overvalued for that safety.

Enbridge in 2009 had a price-earnings ratio (the price paid by an investor for every dollar of profit) of eight, which is historically quite cheap for the company.  Since then, Enbridge’s stock price has simply gone up — until recently.  It now owns a P/E ratio topping 50. This is beyond expensive for a pipeline company, even one with significant growth expected.

As a result, this “very safe” company has a real risk of price declines unless its profitability rises meaningfully.

On the flip side, Barrick Gold (which I now own) was trading at 50 times earnings in 2009 and is now trading at forward earnings of eight.  Forward earnings are based on the price of a company for every dollar of expected earnings in the next year.

This does not suggest that everyone should sell Enbridge and buy Barrick Gold, but it does show that the old adage of “buy low and sell high” is hard to do, although always in style.

Of course, things that are low can go lower, and things that are high can go higher, but when it comes to valuations, they often eventually come back to their normal ranges.

Today, many, but not all, income investments are expensive from a historical perspective.

Strike 2: When interest rates go up, income investments such as utilities, REITs, bonds and preferred shares usually go down in value.

After a three-decade period of interest rate declines, it certainly looks like we hit bottom in the first few months of 2013. With 10-year Government of Canada bond yields comfortably under 2%, there was little room to go down further. Having said that, the super-low interest-rate environment not only lasted longer than anyone expected, but we are still living it today since 10-year rates are under 3%.

The key is that the trend has changed. While rates may move in fits and starts (not always going up), the long-term trend is definitely higher, and that is not good news for interest-sensitive investments, because it starts to make risk-free GICs look more compelling.  It also makes the cost of leverage much higher for these companies.

Strike 3: The investment cycle suggests it is time to move out of interest-sensitive sectors.

Fidelity Investments in the U.S. recently put together a report on how different sectors of the market perform depending on where we are on the business cycle.

The key takeaway is that in a recession phase of the market, the clear winners are consumer staples, utilities, telecom and health care. We are past that phase in North America.

The report then goes on to outline what sectors in the U.S. do well in the early-growth, mid-cycle and late-cycle stages.

Some might think we are past the early phase of the business-cycle recovery, but the fact that central banks haven’t yet raised interest rates suggests we are still likely in the latter stages of the early phase.

In this stage, consumer discretionary, materials, industrials, technology and financials usually outperform, while energy, utilities and telecom lag. We are seeing that right now.

As we head towards the mid-cycle, when interest rates begin rising, technology, energy, industrials and health care tend to outperform. It is not until the late stages of a business cycle that utilities and consumer staples start to reemerge as places to be overweight. We are likely at least a year away and possibly a few years from that stage.

These are but a few of the many key pieces of information that might go into your portfolio choices, but they certainly help to explain the performance changes in income stocks.

Some things, of course, have not changed.

Income remains important. Low volatility is still highly valued by many investors, but the focus needs to be about corporate cash flow and profitability, not yield. This is something that some investors have forgotten in the search for ever-higher yields. When a company can’t maintain its high income payout, the punishment is severe. Just look at names such as Atlantic Power, Yellow Media, Chorus Aviation and Just Energy.

Dividend growth is also still tremendously important as a measure of a company’s long-term health. Many historical studies show that companies with strong dividend growth over many years provide greater long-term returns than most other companies.

Sometimes that may mean investing in stock that has a yield of only 1.5% or 2%, but if it is sustainable and growing regularly, then the dividend growth will become a key driver of overall returns. Dividend growth typically means higher future profits, which often results in stock price appreciation as well.

So what does this all mean?

In my view, a traditionally focused income portfolio needs to be changed unless you want to see a long period of underperformance versus the overall market.

Change doesn’t mean the income yield has to drop too much; it may just need to come from a different sector. An example might be that you want more exposure to technology, with large companies such as Cisco or Apple paying 2% to 3% in dividends — and an expectation that they will increase over time. These are companies that my firm currently holds for clients.

It is also important to remember that a lower yield on your portfolio does not necessarily mean lower returns or digging into your capital.

If the total portfolio is growing at a rate faster than $2,000 a month, and you draw down $2,000 a month, you are essentially not touching your capital. It doesn’t matter if the portfolio has an income yield of 0% or 5% driving that growth.

Investing isn’t easy, and one of the main reasons is that things are always changing. It is looking clear that focusing only on Canadian income stocks and REITs is now one of those things that should change.

Ted can be reached at tedr@tridelta.ca or by phone at 416-733-3292 x221 or 1-888-816-8927 x221

Bond market review – March 2013

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The hunt for yield will remain the consistent theme for 2013. In this 30 year low interest rate environment as governments across the globe are looking to reflate the economy.

At TriDelta Investment Counsel, we are constantly seeking opportunities to enhance portfolio yield and returns by actively managing the portfolio and applying tactical shifts along the yield curve and with credit quality.

Persistently low inflation readings will keep central banks at bay suggesting that we are sometime away from rising interest rates. Although ironically, the Bank of Canada may actually be forced to consider a cut to its overnight lending rates because of recent sluggish growth and anemic inflation readings.

Political and economic turmoil persist in Europe, although economic growth in the US is tilted higher. The Federal Open Market Committee (FOMC) will likely stay the course with Quantitative Easing (QE), as benefits outweigh the costs. However, tapered QE purchases in the months to come will be mitigated by smaller deficits and a projected decline of $260 billion in bond issuance in the US. Growth, inflation, and job targets, none of which are binding constraints for the US Federal Reserve, will not force the Fed off its agenda to maintain low interest rates for awhile.

We believe interest rates will stay low for a prolonged and indefinite period.  The bond market is far from being complacent given the disaster experienced during the financial crisis of 2006 to 2008.  Fixed income investors are still seeking yield; however, less from duration and more from credit.  At TriDelta we continue to monitor and favour:

  • Gradually, and if appropriate, increasing our bond portfolio’s overall term to maturity (duration) to take advantage of higher interest rates on longer term bonds.
  • Take advantage of the premium interest rates paid on corporate bonds versus the low rates on government bonds.

At TriDelta we have structured our portfolios to provide ‘risk adjusted returns’ by ongoing monitoring of market internals and seizing what we see as opportunities to outperform. We have opted to:

  • Remain a little shorter on term to maturity than the overall DEX Universe Bond Index for most clients.
  • We have over weighted the belly of the yield curve (and underweighted the wings) by not taking a significant duration risk.

bonds‘Yield curve’, ‘sector’ and ‘duration’ allocation is important in bond portfolios; as such, we take these into consideration as we design and manage our portfolios.

We believe that investors are fearful of higher overnight lending rates, but central banks have little control over the rest of the yield curve (aside from central bank operations; such as, quantitative easing) and as such have made portfolio tactical shifts to put the odds in our favour.

Lastly, higher quality non-government bonds (known as investment grade bonds) continue to remain cheap, whereas slightly lower quality (known as high yield bonds) are particularly cheap when compared to US equivalents.  We believe that there is a good likelihood that these Canadian bonds outperform their US counterparts.  In a worst case scenario, we believe corporate bonds will perform better than government bonds.  Our portfolios are overweight in corporate bonds for this reason.

The yield-to-maturity for the Core and Pension Models is at 4.64% and 3.59% which will help cushion any decline, or add to the capital gains.

At TriDelta we feverishly monitor trends and look to capitalize on the tactical opportunities available to boost bond portfolio yield and returns without sacrificing our capital preservation and seeking a consistent stream of income mandate.

Article written by Edward Jong, VP Fixed Income at TriDelta Financial

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