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Portfolio Managers Matt Fruhan, Joanna Bewick, and Rob Galusza discuss the investment landscape at a recent event in Palm Beach. See the video clips now.
The December Fed meeting brought news that many investors had been discussing for months: the central bank will begin to taper the monthly bond purchases that have supported low rates, higher stock prices, and the economy. Along with news of the taper came assurances that the Fed will keep short rates low for longer. Stocks responded with a rally to new highs, while the bond market was little moved.
But what happens next? Will rates rise from here, and where can investors looking to generate income from their portfolios find opportunities? Viewpoints brought together five top investment professionals to share their insights at panel events in San Diego and Palm Beach.
- Joanna Bewick, lead manager for Fidelity® Strategic Income, Fidelity® Strategic Dividend & Income Fund, and Fidelity® Strategic Real Return Fund
- Matt Fruhan, portfolio manager, Fidelity® Growth & Income Fund, Fidelity® Mega Cap Stock Fund, and Fidelity® Large Cap Stock Fund
- Rob Galusza, portfolio manager, Fidelity® Limited Term Bond Fund
- Kim Miller, portfolio manager, Fidelity® Conservative Income Fund
- Naveed Rahman, institutional portfolio manager on Fidelity’s equity income team.
Among the highlights: They think that bond market volatility of the magnitude we saw last summer is unlikely to return in the near future. As for opportunities for income investors, they point to dividend-paying stocks, particularly in energy and tech; convertible securities and floating rate bonds; and generating additional yield on cash with conservative bond funds, for those with at least a six-month time horizon.
John Sweeney (Moderator): How much is the Federal Reserve playing into the decisions you’re making as a portfolio manager?
Joanna Bewick: I can’t remember a time when monetary and fiscal policy played such a strong role. When the Fed decided not to taper in September it was a green light for more “risk-on” investments. We’ve never made money fighting the Fed, we’re not going to try to now.
Beyond the Fed; I believe we are in the middle portion of the business cycle—corporate balance sheets and earnings have been strong, though we may be seeing a slowdown. The midcycle is typically supportive of risk assets. With natural support from the business cycle and stimulus from the Federal Reserve combined, it paints a pretty decent picture for risk assets. So I have an overweight to equities right now relative to bonds. But there are certainly strategic reasons why you want to keep bonds in the portfolio.
John Sweeney (Moderator): Given the run-up we have seen, is this still an attractive time for income investors to put money to work in equities?
Naveed Rahman: The U.S. stock market is up about 150% from the lows seen during the financial crisis, with prices on the Dow and S&P above the highs we saw in 2000 and 2007. But it’s important to note that while the price is comparable, the valuations have changed. The last time indexes set new highs in 2007, the price to earnings multiple was about 18, and during the dot-com bubble in the early 2000s, the price-to-earnings multiple was 30. As of November, the price-to-earnings ratio for the S&P based on estimated earnings for the next 12 months was about 16.5.
That suggests that the market is not exorbitantly expensive, but it also is not cheap. The recent price-to-earnings ratio falls within the range of fair value: There are individual pockets of the market that I have been pretty excited about, and there are pockets of the market that we’re actually quite concerned about.
Matt Fruhan: I think it’s important to remember that equities, not fixed income, have been the beneficiaries of growth over time. Unlike most bonds, stocks have no maturity date—they are essentially perpetuities. So if you think that growth is going to occur in the global economy over the next 5, 10, 20, or 30 years, that long-term growth should help drive returns for the equity investor. The equity investor holds the call option on growth, and it is growth in corporate earnings that helps to provides the capacity for an increasing income stream over time, versus a "fixed income."
John Sweeney (Moderator): Is there a case to be made for investing in bonds in today’s rate environment?
Kim Miller: Many of the concerns regarding bonds come from fears that rates will rise. The case for bonds now starts with my view that there is no serious near-term impetus for interest rates to rise dramatically from here.
Inflation has been very contained, the Federal Reserve is committed to keeping rates low for the economy, and it seems unlikely GDP growth would rise enough for bond rates to rise dramatically from here. In June, we had something of a correction, and rates are much closer to equilibrium in the market.
Now the Fed has announced plans to taper, but I don’t think the market is likely to react as violently as it did in June. I think we have undergone a lot of the pain.
Joanna Bewick: When we saw rates move in the second quarter of 2013, you had the Federal Reserve talking about tapering, the Bank of Japan announcing massive quantitative easing, and some real serious interest rate volatility coming from China. So I think the synergistic effect of the three largest economies in the world doing really active monetary policy combined to create some of that volatility. And that’s why I agree with Kim that we aren’t likely to see that kind of volatility happen again anytime soon, because it was such a strange period, and a lot of the impact of tapering is already priced in.
I think we need to be really careful about thinking about bonds in today’s rate environment. We want to keep them in our portfolios because they tend to be a portfolio stabilizer and they offer income regardless of the rate environment.
For example, from 1941 to 1981, the United States had 40 years of rising interest rates. The average annual return for the intermediate Treasury bond was around 3.3% (see chart below). So we need to have lower expectations for returns in fixed income going forward, but I don’t think we should be thinking about bonds being in a disastrous type of return environment, given that kind of historical data.
Rob Galusza: The hopeful story for bonds is that the Fed’s initial moves toward tapering will let rates drift higher and normalize a bit. While the low-rate policy by the Federal Reserve has focused on trying to reignite the economy, savers have paid the price. Slightly higher rates could help balance this out.
With regard to Matt’s point on long-term income prospects, certain sectors of the bond market will also be beneficiaries of growth. We have already seen indications of this in the credit market where strong corporate balance sheets have supported a narrowing in yield spreads over time.
John Sweeney (Moderator): Naveed, where do you see risks and opportunities for dividend investors going forward?
Naveed Rahman: Let’s start with the risks. There are parts of the equity market that have begun to resemble bond proxies. Stocks in these sectors, including utilities and real estate investment trusts, have grown increasingly correlated to the 10-year bond. When rates rose last summer, these stocks suffered. So the funds I work on were underweight those sectors.
Going forward we are most interested in technology and energy. A number of large technology companies are realizing they have large amounts of cash on their balance sheets and are generating prodigious amounts of cash flow, and cannot reinvest all that cash as successfully as they could 10 years ago. So returning some of that capital back to shareholders in the form of a fixed dividend is just a smarter capital allocation policy.
Within energy, we are just getting started on a long-duration transition to being a much larger producer of low-cost natural gas. There will be a number of beneficiaries from the “shale gas boom,” including the companies that will enable the infrastructure upgrade of our energy infrastructure.
In general, I am optimistic about dividends increasing. There is a tremendous amount of cash on corporate balance sheets—more than 25% of the capitalization of U.S. equity markets. At the same time, the market is starved for income, and management teams understand that. But more importantly, the management teams that make decisions on capital allocation are increasingly compensated in restricted stock as opposed to stock options—that means their interests are aligned with the shareholder to value dividends.
Matt Fruhan: Roughly 12 to 18 months ago, the S&P 500® Index's dividend yield crossed above the yield on the 10-year Treasury, and investors increasingly looked for yield from equities. The first stocks they bought looked a lot like fixed income—that is the high-payout-ratio, high-yielding, but growth-constrained parts of the equity market. Utilities, telcos, and REITS were very good investments. But as yield seekers flocked to these stocks, their valuations moved to absolute and relative peaks. I think the next equity domino to fall will occur when investors shift their focus from current yield to the highest future yield. So I'm looking for companies that can offer increasing income to investors through both unused payout-ratio capacity and earnings-growth potential. These dividend-growth opportunities exist across most sectors of the market, including media companies, retail, tech, and others. So, there have continued to be a lot of areas to source both yield and growth in the market at very attractive prices.
John Sweeney (Moderator): Joanna, can you describe where you see opportunities within the equity and bond markets?
Joanna Bewick: I run three funds: one that focuses on dividend income, one focused on bond income, and one focused on inflation protection. Within the dividend portfolio, I invest in high-dividend-yielding equities, convertibles, preferred securities, and REITs. As of our last disclosure date for fund holdings, that particular portfolio was overweight equities and convertibles. We were underweight preferred securities and generally neutral on REITs.
When it comes to the bond portfolio, it was underweight Treasuries, because they tend to be the most interest rate sensitive. The fund was also underweight developed debt outside the U.S. The fund was overweight high-yield-debt, and emerging-market-debt.
If you’re concerned about a rising interest rate environment in a bond portfolio, I think it’s important to do a couple of things. Think about spread product where you get paid for taking on credit risk, so things like high yield. And consider going outside the U.S. bond market. If you don’t like the interest rate environment here in the U.S., find another interest rate environment. Countries around the world have their own central bankers, their own economies, and their own interest rate cycles going on. So that’s another way to offset U.S. interest rate risk, though you may have to contend with current risk.
Finally, with the real return portfolio, in terms of inflation assets, the fund was actually underweight TIPS and commodities and overweight the real estate portions of the portfolio and floating-rate debt. With floating-rate debt, as interest rates go up, what you earn from floating-rate debt also increases.
John Sweeney (Moderator): Many retirees may be trying to get to 4% yield? Can they do that in this rate environment?
Joanna Bewick: It is possible. I think you need to put together a diversified portfolio for income, which I think has three pillars. The first pillar is a multisector bond fund that includes some Treasuries, high-yield debt, and non-U.S. debt. The second pillar is high-dividend-yielding equities. The third pillar is inflation protection, which may include floating-rate debt, TIPS, commodities, and real estate.
So how can you get to a 4% payout? Let’s say Treasuries yield 2.8%, you can get almost 75% of the way there with no credit risk. So then you add in some other asset classes in order to make up the rest: with things like equities, high-yield bonds, non-U.S. debt, convertible debt, and preferreds. You diversify and take on some more risk, but you can make up the difference.
John Sweeney (Moderator): So Naveed, certainly there have been some stocks paying 4% or more. Should investors just load up on those?
Naveed Rahman: I think the relative yield of stocks and bonds makes a compelling case for equity income, but we don’t focus solely on the current level of dividend-yield. Yield is important but can sometimes be overly seductive. We generally avoid investing in the top 10% of dividend yield stocks— more often than not there is something fundamentally challenged about those companies, and the market is worried about the sustainability of the dividend. And my team’s analysis would suggest that top-yielding stocks have a better than 1 in 10 chance of cutting their dividend, which can be disastrous for investors.
So, we try to focus on measures like free cash flow yield. If the free cash flow yield is 6% or 7%, and the dividend yield is 2%, and you think management is committed to shareholders, it suggests that the dividend can grow. Because at the end of the day, dividends are paid out of cash flow.
John Sweeney (Moderator): Kim, what about investors with lots of cash. Should they consider short-term bond funds?
Kim Miller: Well, it depends on your needs for that cash. There are two main reasons investors look at short-term bonds funds.
The first is to complement their cash position. Cash in money markets, CDs, and savings accounts has been paying next to nothing for five years. For money you need to pay the bills or mortgage, you may have to accept those low yields. But a lot of cash held by individuals doesn’t need to be readily accessible. Short-term bond strategies allow investors to earn incrementally more income without significant risk if interest rates do rise.
The other primary use is to shorten duration. Some investors have been adjusting their bond portfolios because of concerns about rising interest rates. But you don’t want to move into cash and see your savings erode if there is inflation—so you could move a portion of your portfolio to short-duration funds, which tend to have less price volatility and reinvest at higher rates more quickly if rates do rise.
Rob Galusza: Within my funds, I am overweight risk assets. Owning short government securities is not very advantageous where yields are at this point. So, I am trying to capture incremental yield through corporates, commercial mortgage-back securities, and agency mortgage-backed securities that might offer more income but are still suitable for these kinds of fixed-income mandates.