A recent investment trend has been the decoupling of eurozone sovereign debt into two distinct camps: the bonds of those countries which the market considers sound and well managed, and the rest. The rest includes all those countries previously assumed (erroneously, it transpires) to benefit from the largesse of Germany and vague notions of the European collective spirit.
If a company’s cash generation remains intact the implication is a pickup in dividend yield- Martin Webster
As capital has moved to the true safe havens, yields have compressed to historically low levels. Germany and the Netherlands have recently sold bonds at a negative yield. In other words, the market is effectively prepared to pay those countries for the pleasure of lending them money. It reflects a tremendous fear of default from other alternatives.
There are other pronounced fears out there. The US has recently sold inflation linked bonds, also at a negative yield. This reflects a view that Fed policy of seemingly limitless quantitative easing will lead to inflation further down the road.
Given that AAA nominal yields have been compressed to record lows, and the value of the capital is at risk from inflation erosion, an investor requires ever more capital in order to generate the same constant purchasing power.
We identify with those investors who feel that we live in a world where the systemic eurozone risks have reached such elevated levels that a safety first attitude is justified – even at negative yield. After all, it is better to lose a bit of money rather than a lot.
However, there are some investors (the majority, one assumes) who do not have the luxury of putting ever more fuel into an income generating engine. They need more miles per gallon – they need their capital to generate a higher yield. Let us consider the options available.
1) Go further out along the yield curve.
Two year German bunds are currently yielding 0.19 per cent. To put that in perspective, an investor would need to invest €5.3 million in order to generate the princely sum of €10k (gross) per annum. A five year yields 0.9 per cent, requiring €1.1million to generate the same €10k. A 10 year yields 1.95 per cent, requiring €513k to generate €10k. A 30 year yields 2.6 per cent, requiring €385k to generate €10k. So you are ok if you have a spare €385k kicking around, are prepared to invest on a 30 year time horizon, and can live off €10k gross per annum – even after inflation raises the cost of living!
2) Lower quality sovereigns.
For example, 10 year Slovakia (rated A) is yielding 4.6 per ecnt, requiring €217k to generate €10k. The forthcoming MGS 2022 bond will yield in the region of 4.3 per cent. Recently, S&P downgraded Slovakia’s and Malta’s credit rating (A-), together with seven other European sovereigns.
3) Higher quality corporate.
For example, GE Capital 2021 (AA) yields 3.9 per cent.
4. Lower quality corporate.
For example, Vivendi 2021 (BBB) yields 4.7 per cent.
Although one can extend even further down the quality scale in order to generate higher returns, one would have to enter the sub investment grade arena. The title itself suggests it is an unworthy place to park your hard earned savings. We make the observation, however, that just below investment grade the yield picks up substantially – a reflection of capital concentration in investment grade.
Naturally, sub investment grade bonds are considered to have a higher risk of default. Bonds which get downgraded from investment grade to sub investment grade are often sold off dramatically, despite it being ‘only’ a 1 step drop in quality. This is often due to the fact that bond funds will have clearly defined mandates, which will often include a restriction to invest exclusively in investment grade.
This might give rise to a risk/reward sweet spot potential. For example, Stena 2020 (BB+) yields 9.7 per cent.
The above gives a broad overview of generic bond based income options. If an investor is prepared to hunt outside the bond arena, the equity market offers a number of interesting high dividend yield plays. Risk aversion has tended to take money off the equity table. However, if a particular company’s cash generation remains intact (and many are growing cash flows strongly), the implication is a pickup in dividend yield.
We think dividends are going to play an important part of an investor’s total return. Last Monday, Capita Registrars reported that UK companies paid out a record £68 billion (up 26 per cent over 2010) in dividends: “Record dividends are providing a real bright spot for investors against a very gloomy backdrop of crisis in the eurozone and a stalling economic recovery in the UK.” They also highlighted the potential for special dividends – an upside surprise potential that a bond cannot offer. In part 2 of this article we shall explore some ideas for high dividend payers, with a wide search but a number of specific selection criteria.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Webster is head of equity research at Curmi and Partners Ltd.