For Whom the Bond Tolls: Low Rate Beneficiaries in a Rising Rate Environment
Sluggish growth and aggressive central bank actions following the Global Financial Crisis pushed interest rates down to unprecedented levels, even negative outside the US, for longer than many would have expected. Investors’ resultant demand for yield (and growth) has supported an unusually disparate group of stocks, all of which might experience meaningful and justified deratings as interest rates begin to lift off from historic lows. This poses a particular concern for us as value investors because we must continuously be on guard against stocks whose apparent cheapness is actually a sign that their fundamentals are in imminent danger of deteriorating. Indeed, there are many monsters lurking beneath the bed that the Fed has made.
We are especially interested in identifying companies whose business model, or stock price, has benefited from the prolonged period of unconventional monetary policy that may be on the verge of ending. Investors in US companies offering high yields, carrying heavy debt loads, issuing debt to buy back stock, or expecting high growth rates have all prospered on the back of the decline in interest rates. These stocks, while different in many defining characteristics, are all negatively exposed to rising rates. Meanwhile, we believe more unloved groups such as US financials, materials, and higher quality value names are well-positioned to outperform on a relative basis if monetary conditions continue to tighten.
Bond surrogates: stocks with a high beta to bonds
As Exhibit 1 indicates, US stocks whose returns are most sensitive to bonds have seen their valuations climb dramatically since late 2008/early 2009. Bond surrogates are defined as the top quartile of the market on trailing 1-year beta to 7- to 10-year US government bonds.1 This group currently trades at a 20% premium to the market. We compare these stocks to those in the bottom quartile, which have seen their relative valuations decline precipitously. The valuation gap between stocks with the most and least sensitivity to bond prices is near the widest it has been over the last 12 years. Investors have preferred to own companies whose business models and/or balance sheets are most amenable to a low rate world. Stocks with a negative beta to bonds have, by comparison, been shunned.
The composition of the high beta to bonds cohort is no mystery. It consists primarily of companies from the REITs, Utilities, Telecommunication Services, and Consumer Staples sectors, which traditionally offer higher yields and/or stable and predictable cash flows (see Exhibit 2). The valuations of these high-yielding bond surrogate stocks expanded aggressively in the rate cutting aftermath of the Global Financial Crisis (GFC) and more so during the first cycle of the European Credit Crisis in 2011. Many of the companies in this high-yield cohort are less economically sensitive and of higher quality than the broad market, offering safety in an uncertain world. REITs are perhaps the exception, but their rich yields have proved too tantalizing to yield-starved investors. Given current elevated valuations for these stocks, however, their role as “safer” equities is suspect at best. Even if one believes lower rates will last a while longer, this possibility may already be priced in. If, however, one’s view is that longerterm yields are set to rise, then bond-like equities look like an explicit anti-value position.
Highly-levered non-financial companies2 represent another beneficiary of the low rate world. Historically, companies burdened with the most significant debt loads have traded at about a 14% discount to the market on our composite value metrics. As Exhibit 3 indicates, that discount tends to widen leading into and during recessions as cash flows dry up, interest coverage wanes, and defaults rise.
Aggressive action by the policymakers muted the market’s negative reaction to levered companies during the GFC. Immediately following the crisis, levered firms were valued in line with historical norms. Since 2010, investors have been anticipating stronger earnings growth, due partly to falling interest burdens from the lower rates on offer, and re-rated these firms accordingly. Today, the most levered companies trade near parity with the market, offering no discount for their more precarious balance sheets. Perhaps the market has forgotten what can happen to levered firms in an economic downturn? As Exhibit 4 shows, the median percentage of EBIT being diverted to interest payments for this cohort of companies has remained roughly constant since the GFC. Interest payments have grown in line with EBIT, even as interest rates have fallen. This should be a clear warning sign to anyone familiar with the vicious dynamics of forced deleveraging.