From Seeking Yield to Seeking Profits

How low can you go? It is a question that gets asked often in a limbo dance contest. These days it is a question that gets asked often with respect to sovereign bond rates. In the past, it would have been thought that zero would be as low as interest rates could go. In the present, that isn't the case.

To Zero and Beyond

Zero hasn't been the floor. Instead, market participants have been floored by the recognition that there is now approximately $12 trillion of sovereign bonds with negative yields.

Think of a limbo bar being placed on the floor and a contestant burrowing their body below the surface to go under the bar. Hard to believe it could happen, isn't it? Yes, sovereign bond rates can, and have, gone below zero with central banks playing an active role in that unbelievable move. Other forces have been at work too. Buying by pension funds and insurers, an aging population aiming to preserve capital, concerns about disinflation/deflation, and political uncertainty have also been part of the repressive mix.

What do negative yields really mean other than this is a really screwy financial world in which we live?

They mean that anyone, or any institution, buying a bond with a negative yield is effectively giving the sovereign entity an interest-free loan. Even more to the point, they will lose money by doing so because they won't get their full principal back at maturity.

Room to Run

Bond rates in the U.S. haven't gone negative (thankfully), yet they have certainly come way down. In fact, the yield on the benchmark 10-yr Treasury note and the 30-yr bond recently hit record lows.

Some think they could be headed lower still -- perhaps much lower -- as their "high yields" attract interested buyers from abroad. In turn, it is thought that worries about the stock market being overvalued and the economy failing to achieve escape velocity will continue to drive safe-haven buying interest.

Notwithstanding such concerns, the added fact of the matter is that the S&P 500 just established a new record high as longer-dated bond yields hit a new record low. Think investors aren't hungry for yield? Think again.

The dividend yield on the S&P 500 is 2.16%. That's not particularly lofty, but pitted against a 1.53% yield for the 10-yr Treasury note, it looks downright juicy.

It has been a draw for many investors in this low-yielding world, as have the even juicier yields offered by hefty dividend payers in the utilities, telecommunications services, and consumer staples sectors. Dividend aristocrats, meanwhile, have had some magnetic appeal as well based on their dependable dividend growth and relatively high yields.

Concentration Risk

Everyone seems to love these high-yielding areas of the stock market. A day doesn't go by when they aren't touted by some pundit as a place to invest in this low-yielding world.

Of course, it is a well-known axiom in the capital markets that when "everyone" is thinking and saying the same thing, it usually means there is a heightened risk of the opposite happening.

This is an important point because the consensus view is that interest rates are bound to go lower, thereby bolstering the view that high-yielding stocks are destined to keep pressing higher.

Now, we don't know any better than anyone else what the future holds, but we do know from experience that it is typically a setup for short-term disappointment when everyone is beating on the same drum.

A High-Low Game

Bond rates have come down sharply while high dividend yielders have gone up sharply. Those respective moves are correlated with the former driving the latter. It doesn't take much to imagine, then, what could happen to the stock prices of high dividend yielders if bond rates jumped noticeably from their currently depressed levels.

It is concentration risk at its finest and it is a risk investors may want to mitigate by taking some money off the table in stocks that have been driven up a lot less by fundamentals and a lot more by efforts to seek higher yields.

Wrapped up in the concentration risk is price risk for many of these stocks, which will be rolled back if the group think turns in the other direction.

That price risk may be entirely acceptable to someone who just cares about receiving a dependable dividend payment. We get that and understand that you might see little need, or no need, to do anything at this juncture. That mentality fits the guise of a long-term investor who understands that stable dividend growth is a cornerstone of long-term investment success.

Still, for others with a shorter time horizon and a weaker stomach for price risk, the time may be nigh to seek some profits from the seeking-yield trade. It's a trade that everyone seems to be favoring and it is stretching valuations in many respects.

The S&P 500 Utilities sector, for instance, is up 20% year-to-date, versus a 6% gain for the S&P 500, and is trading at 18.4x estimated forward twelve month earnings. That's a 29% premium to its 15-year historical average, according to S&P Capital IQ. The S&P 500 Consumer Staples sector is up 10% year-to-date and is trading at 21.9x estimated forward twelve month earnings, which is a 30% premium to its 15-year historical average.

Clearly these sectors, which are expected to deliver only low-single digit earnings growth this year, have been a big beneficiary of the search for yield.

How high can these high-yielding dividend payers go? That may ultimately depend on how low bond rates go.

What It All Means

The path to negative rates here is still a fairly long one, yet it has been a fast ride down in recent months -- so fast that it wouldn't be any surprise to see a backup in rates as concentration risk and price risk hits home in the bond market.

In many respects, rotation has been the name of the game in this market and it sometimes happens in whipsaw fashion.

It may be prudent to defer seeking yield for now in the interest of taking some profits, which nobody ever went broke doing.

Patrick J. O’Hare, Briefing.com

S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market. Indices are unmanaged and one cannot invest directly in an index.

Data and rates used were indicative of market conditions as of the date shown and compiled by briefing.com. Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security. Past performance is not a guarantee of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk.

Park Avenue Securities LLC (PAS) is an indirect, wholly-owned subsidiary of The Guardian Life Insurance Company of America (Guardian). PAS is a registered broker-dealer offering competitive investment products, as well as a registered investment advisor offering financial planning and investment advisory services. PAS is a member of FINRA and SIPC.

2016-26079 Exp 7/2018

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