Fund manager viewpoint: End of the bond run

Dr. Ana Armstrong, chairman of Distinction Asset Management, on why investors should consider rotating to high-dividend paying equities.

Risk averse investors have allocated huge amounts of capital to bonds over the past two years, based on low cash rates and a potential deflationary environment. Despite high unemployment and a weak economy, the UK has experienced quite high and persistent inflation.

The Retail Price Index (RPI) is up 4.7% over the past year. This is before the increase in VAT, which will push inflation higher in 2011. With the printing of money, quantitative easing and the destruction by many governments of their currency’s purchasing power to gain short-term competitive trade advantages, we expect inflationary pressures will continue to grow in the coming years.

The spectacular run in sovereign debt is over. Real yields on government bonds are already non-existent. Inflationary pressures and sovereign risk will push longer term interest rates higher during the coming year. We expect a steepening of yield curves as Western central banks will keep cash interest rates extremely low for all of 2011.

The strongest returns in bonds will come from short duration high yield corporate bonds. Income-seeking investors will favour securities with a yield advantage and with the financial system pumped with liquidity we do not expect short term spreads to rise during the year.

Longer duration, high-yield instruments will be at greater risk from widening credit spreads and higher long-term interest rates. The market’s average default rate has been 4.6% since 1985. Through the first three quarters of 2010, it has been 2.5%, and we expect it will be less than 2.5% in 2011 while liquidity is abundant. We may begin to see an uptick in defaults should interest rates rise or if liquidity is removed from the financial system.

2011 will see many investors moving away from bonds with negative real yields and allocate towards high yielding equities as a better valued alternative. The gap between equity earnings yield and bond yields are at all-time highs, and companies enter 2011 in the best financial shape for the past two decades. The corporate world has a much better balance sheet than Western sovereign nations and households.

Capital structure arbitrage among high dividend payers and under-geared companies will push stock prices higher. Many companies will increase borrowing at low rates to buy back shares in 2011.

This can be cash-flow positive for high dividend paying companies as the interest rate on debt incurred is less than the dividends that would have been on the shares which were repurchased. We also expect M&A will pick up, and under geared companies with high cashflows will become attractive takeover targets.

We are very positive on global water stocks utilities and telecoms in 2011. These defensive stocks are not viewed as sexy, and often do not have a near-term catalyst but investors are paid to be patient as many stocks in these sectors have dividend yields over 6%. We are concerned that the more cyclical areas will disappoint in 2011 as Western economic growth may disappoint.

Infrastructure assets are another area with above average yield and defensive growth.

Emerging markets infrastructure is particularly attractive.

In China, the rapid growth in urban housing and ever increasing number of cars and mopeds will demand more infrastructure, such as power generation, roads, rail lines, ports, airports, subways, and water and waste systems and the PAC II development programme in Brazil ensures a significant expenditure on a range of infrastructure assets.