In 1995, investors who parked their money in investment-grade bonds typically enjoyed yields of close to 8%, in line with the rather high inflation rates of that era. But in the last 25 years, yields have steadily fallen and nowadays, bond investors are not likely to get anywhere near that rate.
“Today, you’re getting barely above 1% for those same investment-grade securities,” says Ben Sheehan, senior investment specialist, equities, at Aberdeen Standard Investments (ASI).
Bond yields around the world were especially hard-hit during the outbreak of Covid19, when US Treasury yields reached all-time lows in March 2020 after the Federal Reserve slashed interest rates to near-zero levels.
Since then, yields have rebounded somewhat, with the benchmark 10-year US Treasury yield hovering around 1.6% and economists expecting a further rise to around 2% in the near term as the economy recovers.
Central banks are expected to keep interest rates low, and amid this sustained lowrate environment, the landscape continues to look bleak for investors who have typically sought yield from fixed-income assets. To that end, Sheehan believes that for investors in Asia, whom he describes as having “an insatiable appetite for yield”, many are increasingly turning to equities to fill that gap.
The case for dividend stocks
High-quality bonds have traditionally been viewed as safe, stable investments that ticked the boxes for those interested in preserving capital and generating a regular income through interest payments.
Even for those who preferred the higher returns of equities, bonds served to round out and strengthen a portfolio. For a long time, a rule of thumb for many investors was to have a portfolio split of 60:40 between equities and bonds. Bonds were meant to insulate the portfolio against volatility in the stock market while also generating a stable source of income.
But in the current environment, many investors are re-thinking their portfolio allocations. In March, GIC and Future Fund, two of the world’s largest sovereign wealth funds, said the 60:40 portfolio no longer works as real returns from bonds are too low.
According to Sheehan, dividend-paying stocks are increasingly favoured by yield-seeking investors who want some assurance of a regular income. “Many investors who previously invested in bond funds for income are increasingly taking a hard look at equity income, given the attractive dividend yields on offer,” he says.
Sheehan states dividend availability has been “surprisingly resilient”, pointing out that in the last 12 months, companies in the MSCI All Country World Index (ACWI) — which covers about 3,000 large and mid-cap stocks across the globe — paid out US$1.1 trillion ($1.47 trillion) in dividends. He also highlights that dividend payouts in the US in 2020 actually exceeded those in 2019, despite the pandemic.
As the global economy recovers, Sheehan predicts the level of dividends paid out by companies will remain resilient, making dividend stocks an alternative to bonds that is hard to resist. “The pool of investment-grade bonds earning anywhere close to the yield available for dividends is very, very low,” he emphasises.
To be sure, switching to equities from bonds means taking on more risk. However, Sheehan believes this is something investors are willing to stomach in the current environment. “I think the [low-yield environment has] driven effectively risk appetite that’s very high and present,” he says. But backing this is a confluence of factors that have also boosted overall sentiment and outlook, including an easy money environment given the low interest rates, recent earnings that point to improving fundamentals, and the roll-out of vaccines globally.
Despite investors’ higher risk appetite, Sheehan believes that dividend stocks can potentially provide attractive yields at a better risk trade-off compared to other asset classes, such as high yield or emerging market debt. As such, it may better fit the risk profile of yield investors who have traditionally relied on investment-grade bonds.
For investors who are not keen on investing in individual dividend stocks, dividend exchange-traded funds (ETFs) or dividend mutual funds, which include ASI’s Global Dynamic Dividend Fund, come into play. The US$21 million open-end fund aims to outperform the MSCI ACWI, with ASI stating that dividends have historically been in the 6%-7% range for the last eight years. Based on the fund’s factsheet as of Feb 28, its historic yield is 5.4%. Distributions are paid out on a monthly basis to investors.
As of April 30, the fund’s top holdings include Apple, Microsoft Corp, Samsung Electronics, biopharmaceutical company AbbVie, retailers Target Corp and Lowe’s Companies, Alphabet, semiconductor player Broadcom, Canadian energy company Enbridge, and FedEx Corp.
Nearly half of the fund’s holdings are in US stocks. Sheehan believes the US equity market outlook remains favourable, with benchmark indices hitting record highs earlier this year. While investors need to be mindful of valuations for individual stocks, he expects 2021 to provide a stock picker’s environment amid the global economic recovery.
Despite a recent pullback in the tech sector, Sheehan is confident that the fundamentals of US tech stocks “remain fairly good” on the back of a solid 1Q2021 earnings season, reducing the risk of a major sell-off. Rather, the bigger risk to tech and other growth stocks lies in interest rate movements that could bump up inflation, thus adversely impacting the stocks. For now, despite anticipating a pick-up in inflation, Sheehan does not foresee a significant rise, in tandem with the Federal Reserve’s dovish stance.
He also points out that the fund’s diversified exposure across sectors helps to protect it from being over-exposed to market events, including potential corrections. Currently, its largest exposures are to the financials, information technology, healthcare and consumer staples sectors.
In Asia and emerging markets, which currently makes up about 15% of the portfolio’s exposure, Sheehan points out that companies within sectors such as financials, real estate and technology, are showing attractive fundamentals and delivering decent income.
Value vs growth
Even for income-seeking investors, Sheehan cautions against purely focusing on yield while neglecting capital growth when investing in stocks. As shown over the last decade, the broader market has clearly favoured growth stocks. Traditional dividend funds that have typically been biased towards value stocks that have a lower growth profile, are thereby seen as having a disadvantage. “While these traditional high dividend funds can often offer an attractive income, from a total returns perspective, it’s been a fairly painful experience,” he says.
Instead, Sheehan posits that a balanced approach across both value and growth stocks not only provides investors with total returns across capital growth and income, but also helps hedges portfolios and prevents the risk of either investing style, be it value-investing or growth-investing, outperforming the other.
Currently, the Global Dynamic Dividend Fund has about 45% of its portfolio held in growth stocks and 55% in value stocks.
Given the split, to help sustain income generation and monthly dividends payments, 5% of the fund is allocated towards short-term holdings aimed at capturing regular dividends or special dividend events. “In this 5% capture sleeve, we tactically allocate to about 50 to 80 dividend events. And we do that on a higher rotation basis, which seriously enhances the yield of the portfolio,” Sheehan explains. Sheehan credits the fund’s ability to track and capitalise on dividend events to its overall management rigour — something he claims investors cannot get from simply buying into an ETF. “When it comes to stock selection, we are far more discerning,” he says. The fund has an annual management charge of 1.5%, with an initial sales charge of 5%.
As the hunt for yield carries on, equities will continue seeing heightened interest as investors seek out reliable income.
