A red light is flashing over "bond proxy" income funds

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

See all articles

Since the credit crisis, investor appetite for stocks in companies that appear safe and stable has pushed their prices up to a level where they can no longer be considered safe or stable. This has created a "bond proxy paradox".

Many income funds have taken what we believe are dangerous bond-proxy bets, concentrating investment in traditionally defensive sectors such as food & beverages and tobacco for their income streams. In doing so, they have been risking their investors’ capital.

While stock prices in these sectors have cooled a little recently, valuations remain extremely high. This means that investors in funds with high exposure in this area could face significant losses on current valuations, if they revert to a more normal level.

The lines on the charts below show the relative cyclically-adjusted price to earnings (CAPE) valuation of the banks and tobacco sectors. On the right-hand side of the charts you can see the dividend yield of each sector shown as a percentage.

The UK:

On a global basis:

Even after last month’s fall, the tobacco sector is towards the upper end of its historic valuation range. Conversely, banks are trading at a significant discount to the wider market – and yet, as a sector, banks are paying an average dividend yield which is similar to what’s on offer from tobacco stocks. 

Valuation protection

The focus of the Schroders Value Team on valuation means that both our UK and Global Income portfolios are positioned very differently from most other income funds. Our preference for banks – a sector where most income investors still fear to tread, but where the prospects for income and capital growth are compelling – is a good example of this.

Find out more at The Value Perspective.