Red Flags In A World Upside-Down: Stocks For Income, Bonds For Appreciation

By Ellie Ismailidou

Demand for stocks that offer high dividends and for bonds saddled with record-low — and even negative — yields has shaken up the traditional use of bonds and stocks in portfolios.

“Investors are buying bonds for capital appreciation and stocks for income. The world has turned upside down,” said James Abate, chief investment officer at Centre Asset Management LLC.

The shift, according to Abate, has been fueled by central-bank stimulus inflating government-bond prices across the world, pushing yields on nearly $12 trillion of government debt into negative territory.

“It is a poison brew that central banks keep serving us,” Abate said.

Treasury yields have tumbled for six straight weeks, falling to record-low levels on Friday despite hiring news that suggested the economic expansion remains intact. On Monday, as the S&P 500 marched to an all-time high, yields moved somewhat higher but were still hovering near all-time lows.

Meanwhile, since the beginning of 2016, so-called dividend aristocrats SPDAUDP, +0.53%  , which include companies that have raised dividends for at least 25 consecutive years, have outperformed the main stock indexes, rising 12.5% so far this year, compared to 4.8% for the S&P 500 SPX, +0.84%  and the Dow industrials DJIA, +0.72%

On the corporate side, the yields on higher-rated, investment-grade corporate bonds have also been dragged lower in the global bond rally, mainly due to foreign demand from investors fleeing negative interest rates abroad.

As a result, a rough survey by Jefferies’ global equity-strategy team showed that at least one-third of S&P 500 stocks offer dividends higher than the same company’s bond yield.

And yet, investors don’t seem to be discouraged by anemic yields and demand for bonds “seems to be insatiable,” said Aaron Kohli, interest-rate strategist at BMO Capital Markets, who thinks the bond market is now expensive.

Last week, inflows to U.S. fixed-income funds and ETFs jumped to $7.95 billion, the highest inflow since February of 2015, according to a report by Bank of America Merrill Lynch released Thursday and charted below.

Bank of America Merrill Lynch

“There’s a perception there’s a greater fool behind you,” Kohli said, pointing to the strategy of buying a bond with the intention to sell later at a higher price.

But the main forces behind the rally, Kohli added, are central-bank purchases that keep fueling demand and propelling prices higher.

In the near-term, this short-term strategy might work for some bond investors, said Chris Molumphy, chief investment officer of Franklin Templeton’s Fixed Income Group. But in the long term it could be dangerous, as “bonds should be primarily purchased for diversification and portfolio-risk reduction and only secondarily for the anticipation of higher prices.”

“At some point there needs to be an unwind of all this [central-bank] purchasing and tremendously accommodative activity,” Molumphy said.

He’s not alone in pointing out that the government-bond market is in danger of a repeat of the 2013 “taper tantrum.” At that time, yields skyrocketed as government bonds got hammered after a mere suggestion of an imminent reduction in bond purchases by then-Fed Chairman Ben Bernanke.

What’s more, the recent divergence between the main U.S. equity indexes and benchmark Treasury yields has been flashing “mind the gap” signals that fuel fears of a sharp correction.

As the following chart shows, there is a strong positive correlation between changes in the S&P 500 and the 10-year Treasury yield, with yields falling when stocks sell off and yields rising when stocks rally. The recent divergence, in which Treasury yields have tumbled to record lows as stocks are marching toward record highs, bucks the trend.

Centre Asset Management

“Too often we have heard how declining interest rates are good news and are used as a justification for investors being pushed out the risk spectrum. We disagree and argue this time is different and the decline in rates should be interpreted as a bad sign,” the analysts noted.

Source: Investors are trading bonds like stocks — and that’s a red flag

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