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Constructing a resilient equity yield portfolio as interest rates rise

November 2016

By Antares Equities

Yield focused companies have outperformed cyclical companies (those sensitive to the business cycle) for years as weak growth constrained cyclical earnings. The uncertain market environment and low global interest rates also contributed to a strong investor preference for defensive and interest rate sensitive yield stocks. The relatively stable earnings of defensive companies were attractive in this environment but such stocks now have quite stretched valuations and have been coined ‘TINA’ (There Is No Alternative) trades. They are very crowded and vulnerable to a change in sentiment which may already be in play.

Dual forces – the resurrection of ‘value’ stocks and potentially higher interest rates

Cyclical company earnings appear to have bottomed recently and begun a tentative improvement. This has reignited investor interest in value stocks – those with share prices that look undervalued relative to their earnings potential. These stocks may provide the investment ‘alternative’ that has been lacking in recent years.

US monetary policy tightening is also important as markets are forward looking and tend to ‘price in’ expected information before it actually happens. If US interest rates are increased again soon, Australian bond yields could start to trend higher as US bond yields rise. This would reduce the attractiveness of yield focused stocks.

Yield portfolios as the popularity of yield stocks wanes

The problem with popular trades is that they can become equally unpopular if sentiment shifts, like it appears to be doing now. A major challenge currently facing yield focused portfolio managers is how to construct an equity portfolio with a high yield that is resilient to a sentiment shift away from yield stocks as interest rates rise. Antares would argue that some types of yield stocks are more vulnerable than others and that the key to creating a resilient portfolio lies in being underweight traditional yield, identifying areas of value and looking ‘outside the box’.

Traditional yield – underperformance likely unavoidable

Traditional yield stocks (eg telecoms, utilities, REITs and infrastructure) are the most vulnerable to rising interest rates as they are seen as bond proxies. They have outperformed significantly for years but as interest rates rise they will most likely underperform. It is hard to be zero-weighted in all these stocks in a yield portfolio, but Antares believes it will pay to be underweight and choosy, only targeting names where rigorous, bottom-up research suggests that suitable returns can still be earned.

Value hunting – are the banks an opportunity?

Areas of value can be hard to find and often they are in unloved sectors. Bank stocks aren’t currently in vogue but Antares believes they should feature in a yield portfolio despite rising interest rates for two key reasons:

  • potential earnings growth – higher interest rates may actually be positive for the banks as it provides scope for profit margin improvement. The major banks also repriced their mortgage books late last year by cutting mortgage interest rates by less than the official cash rate reduction, providing some earnings growth potential.
  • valuation – banks have lagged the rally in yield stocks and valuations are cheap in absolute terms and relative to the overall market. This is very significant as traditional yield stocks and industrials in general are trading quite expensively.
Outside the box – non-traditional yield

Looking “outside the box ” is about finding high yields in companies that may not have traditionally been considered yield equities. This aids portfolio diversification and is advantageous when yield stocks are fully priced (like now). It also accords with Antares’ view that excellent investment opportunities can often be uncovered in less popular parts of the market. Recent examples include Toll Holdings, Aurizon and Tabcorp Holdings. These types of stocks are less affected by a shift in the interest rate cycle as they are not particularly interest rate sensitive. Instead they are more likely to be impacted by stock specific issues and this is what makes them relatively attractive in the current environment. 

Securities mentioned in this article may no longer be in Antares’ portfolio.

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