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Oh-oh seven? – Why so-called ‘bond proxies’ could leave their investors both shaken and stirred

24/04/2015

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

‘Bond proxies’ may sound like a sub-genre of 1960s cinema – The Man from U.N.C.L.E. say, or Our Man Flint – but they are, of course, a more recent conceit from the world of investment. Essentially they are equities that are viewed by the market as likely to grow with the broader economy while generating a smooth and predictable level of profits – and thus a relatively steady stream of income. 

These companies tend to be big-name, ‘blue-chip’ businesses in, for example, the food & drink, tobacco and utilities sectors and, in the low interest rate environment of recent years, they have become highly sought after by income-hungry investors. ‘Highly sought after’ though inevitably translates into ‘highly valued’– something that of course sets off alarm bells here on The Value Perspective. 

Nor should we be alone in our concern to judge by a recent paper that looks at the behaviour of real short-term interest rates over the last 160 or so years. In the world of economic theory, there is a line of thought that posits a link between economic growth rates and interest rates – the only problem being that the theory does not hold up in reality. 

According to The equilibrium real funds rate: past, present and future, the correlation between real GDP growth rates and real short-term rates dating back to the 1850s is almost zero – which has to cast some doubt on the idea that in a low rate environment, yield is more valuable due to sluggish earnings growth. 

The paper was brought to our attention by our friends at Empirical Research Partners, who take this thinking a stage further by also showing that, over a period dating back to the 1929 Wall Street Crash, the relationship between real short-term rates and the performance of income stocks is completely random – that is to say, there is none. 

It is understandable how, in an uncertain economic environment that has seen an extended period of historically low interest rates, bond proxies should have attracted such a weight of investor interest and cash. However, as Empirical puts it: “The use of stocks as yield-driven commodities seems to us a misbegotten idea that is vulnerable to increases in either interest rates or earnings growth.” 

For our part, The Value Perspective would always encourage investors to look at stocks as individual businesses rather than as themes or concepts, such as ‘bond proxies’. The latter approach can lead to generalisation and on to misvaluation and, while that tends to be good news for value investors, it is potentially a lot less positive for those who have already bought into the theme.

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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