In the current low interest rate world, investors have had to bend the rule book. Whereas in the years gone by, you could get a safe and stable income via a portfolio of bonds, it is no more the case. Investors have had to turn to stocks (equities) of companies who produce predictable cash flows year after year in order to get their required level of income. They have had to turn to dividends from bond proxies.
What are Bond Proxies?
Bond Proxies are shares of companies whose cash flows and profits are very consistent – like coupons paid on a bond – and they also pay out a large and stable dividend.
Utilities, consumer staples and tobacco stocks are good examples of bond proxies.
What happens to bond proxies when interest rates rise?
Bond proxies like utilities have recently taken a hammering due to expectations of an increase in interest rates. As interest rates rise, companies that produce consistent but slow growing profits will be sold off and investors will move their money into higher quality government bonds.
When interest rates rise, you would expect to see bond prices fall and thus you would expect to see bond proxies like NG fall as well. The falls in these stocks are down to two main reasons:
The dividend yield offered from bond proxies become less attractive in the face of higher yielding binds.
Due to the high debt load carried by companies in the utilities sector, more money is needed by these companies to service the debt thus reducing cash flows that could have been used to pay dividends.
In short, when interest rates rise, holding bond proxies become less attractive and you would expect the share prices in such companies to decline.
National Grid (LSE:NG) – The perfect bond proxy?
National Grid is the ultimate bond proxy. The company has fairly predictable cash-flows due to its stable operating business of owning energy transmission lines. As long as management don’t do anything stupid, the dividends offered by NG shares should be safe, stable and increase with RPI thus making it a good bond substitute. Instead of getting 2% yield from a long dated safe government bond, you can get a higher 4% yield from NG.
NG’s share price has declined recently due to the threat of rising interest rates. Due to the prospects of inflation, rate rises have now been factors into the market and that is why you have seen bond proxies fall across the board. Now and in the coming month may be a good time to pick up a bargain or two.
One thing to note is that NG has been trading at cheaper levels compared to tother utility companies due to its higher pension deficit. The irony with bond proxies like NG being hit is that bond yields rising should actually help NG with it’s pension problem.
Now predicting interest rates is a very dangerous game. How many times over the past 7 years did you think or hear interest rates were going to rise but didn’t.I would say it is foolish for an individual investor to linger on interest rates and make investment decisions solely on that variable. It is far better to buy an attractively values asset that you would still be happy holding if interest rates went from 0% to 4% over the next few years.
At current price levels, NG certainly offers an attractive proportion to investors that want to firstly preserve and then build their wealth over the long term.
I recently sunk £1169 into NG buying 121 shares. As NG pays a dividend of 0.435p a share a year, I am expected to collect £53 from this purchase over the next year.
Furthermore, it’s looking increasingly likely that NG will give shareholders a special dividend next year as a result of the sale of part of its gas business. NG received £5.4 billion from the sale and they are expected to give shareholders £4 billion in the form of buybacks and a special dividend. According to my rough calculation, the special dividend paid by National Grid is expected to be about 79p. As an income stock, right now NG is second to none.
What should the interest rate be?
Predicting interest rates is a fools game. But I am just writing my thoughts here for the sake of learning purposes and to give people a better idea of how interest rates affect stock valuation.
In economics, there is a common theory that long term interest rates (10 year t-bill) should equal the real GDP growth rate plus the inflation rate. Or in short, long term interest rates should equal nominal GDP growth.
With current expected inflation rate of about 3% and GDP growth of 2%, the long-term inserts rate should be 5%. One of the greatest bond traders of modern times, Jeffrey Gundlach of Doubleline, comes to a similar conclusion on the US economy as he says interest rates should hit 6% in a few years.
What valuations should the stock market trade at according to the interest rate?
Looking at the data from 1955 to 2014, when interest rates have been at the 1% level, the market P/E was 28.82, far above where we are today. When interest rates were at the 4% – 6% range, the US market traded at an average P/E of 23.3. Looking at this, if interest rates shoot upwards, stock don’t necessarily need to re-rate and fall.
As a long term investor, I am interested in investing in strong cash flow businesses at attractive valuations. Sure, stock prices can drop in the short-term and that is why I am in the market over the long-term. I am sure that when I look back 20 years from now, I will certainly be glad to say that I was buying great companies even though there was macro-economic uncertainties.
If 2016 has taught us anything, it is that unpredictability has become the new norm.