A Focus on Total Returns – An Investment Principle True in any Environment
Of the various critiques levelled against economists and financial experts, one of the most interesting has to be that they exhibit “physics envy”. Analysts strive to predict markets through rigorous mathematical formulae, only to find out that finance is much messier in practice.
Take, for example, the tried-and-true laws of supply and demand. It posits that if there is ample supply of an item, its market price should fall. The real-world exceptions are known as “Giffen goods” since it seems that there are certain things that people will buy more of as the price climbs higher.
Today’s corporate bond market provides a good example of this phenomenon. Spurred by low borrowing costs, Canadian non-financial companies issued a record $42 billion in debt last year. Although faced with this supply glut, investors continued to pay higher prices to acquire these instruments.
“Giffen-esque” corporate bonds are the result of the pervasive need for investment income today. In the past, retirees could invest in a low-risk portfolio and live off the income it generated. The “4% rule” – which states that 4% of a portfolio could be withdrawn each year with little chance of depleting the nest egg – became a fairly standard approach to retirement planning. In this low-yield environment, similar to the laws of supply and demand, the tenets of spending at this rate during one’s golden years are now being challenged.
As we noted in our July 2013 Commentary, interest rates are likely to remain below average for the next few years. With this in mind, rather than stretching for yield, we believe a focus on total returns (comprised of both investment yield and capital gains) is a better approach to managing portfolios.
For bond investments, a singular focus on income is likely to result in ill-timed decisions. For instance, at the start of May, a 5-year government of Canada bond provided a scant 1.6% yield, while a similar 30-year bond provided a payout around 3%. But, in exchange for the additional income afforded by longer-dated bonds, investors would be taking on an extraordinarily high amount of absolute risk and a relatively higher [versus shorter-term issues] amount of interest rate risk.
The siren song of yield could also lead to an increased allocation to high-yield bonds. However, as highlighted in the chart above, US junk bonds are paying out about 5% – the same rate that risk-free Treasury bonds routinely provided just seven years ago. This shows that – in a field full of contradictions and exceptions to the rule – today the term “high-yield” bonds is a bit of a misnomer. As readers of our commentaries may recall, we’ve avoided large-scale allocations to this asset class. This is due not only to current valuations, but also because high-yield bonds tend to be much more correlated with equities, which detracts from our diversification efforts.
Finally, on the topic of equities and diversification, investing in stocks solely because they pay high dividend yields is also likely to be an unrewarding strategy. For one, the “quest for yield” trade has resulted in high-dividend-paying stocks becoming somewhat overvalued. In the US, the Utilities sector trades at a 3% premium relative to the S&P 500, well above its usual 14% discount. Curiously, as equities continue to move higher in 2014, we see the defensive, dividend-paying names leading the way. While a preference for high-yielding stocks may boost income now, it leaves portfolios ill-positioned for the long-run. A recent study by Morningstar found that historically, “bond substitutes” in the US, such as Telecommunications and Utilities stocks, fell 0.93% and 3.07% for every 1% rise in Treasury yields. Just like bonds, certain equities are also likely to be hurt by rising rates.
In this low-yield world, it is true that both retail and professional investors need to work harder to find income. While TEIC has implemented strategies to enhance yields in client portfolios, we do not believe that this should be the sole focus for investors. It is important to not lose sight of the big picture, as short-term strategies may not be the best prescriptions for markets that are constantly evolving. A better approach is to construct an “all-weather” portfolio focused on total returns and diversification throughout market cycles. As many investors eventually realize, the short-term trend is your friend…until it isn’t.
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