Equities could be safer move than bonds, experts say

Pension executives seeking to match their plans' assets to their liabilities might be better off investing in dividend-paying stocks instead of fixed-income securities because interest rates are expected to rise in the near to intermediate term, some consultants and strategists say.

In today's market, fixed-income investments intended to reduce investment risk and match payment needs of liabilities are expensive and might add duration risk. In the longer term, dividend stocks of blue-chip multinational companies could become more reliable low-risk investments as rising deficits make the debt of governments less appealing.

The fear of volatility from the financial market crisis that drove pension fund executives to risk-reducing strategies of bonds now threatens to put them at risk when interest rates rise.

“If (investors) want to buy payment certainty they have to pay the market price for it,” Keith Ambachtsheer, president of KPA Advisory Services, a Toronto-based pension management consulting firm, and director of the Rotman International Centre for Pension Management, University of Toronto, said in an interview. And that has become expensive, he added.

Horace W. “Woody” Brock, president of Strategic Economic Decisions Inc., a San Diego-based economic and investment research firm whose clients include pension funds, said in an e-mail: “The time for an all-bond strategy is over for two reasons. First, rates will slowly rise, and capital losses will ensue, if gradually. Second, equities are attractive for reasons that transcend and indeed vitiate concerns over their "riskiness.'”

James Paulsen, chief investment strategist at Wells Capital Management Inc., Minneapolis, said in an interview: “The profile on bonds is very, very risky. ... It looks like a very bad risk-reward profile. One thing we have not had in this recovery is a sustained, noticeable, painful upward move in bond yields. (Bond prices) haven't fallen, not for any meaningful amount.”

“I think that we are going to get that,” he added.

Confidence of consumers “is showing up in the economy” and “that's also running right through the stock market.” Mr. Paulsen said. “That's why the stock market is doing better. But I think ultimately that's going to run through bonds, too. And for (bonds) it's a bad thing. I think we have a real chance of a more significant upward move in yields.”

Mr. Ambachtsheer said: “In the year 2000, buying (growth such as in equities) was very expensive and buying payment certainty (in fixed income) was cheap.” Treasury inflation-protected securities “were yielding a 4% real (return) in 2000” after 3% for inflation. That translated to a 7% nominal return, almost making a pension plan's assumed rate of return.

“Today, it's flipped around. Today to buy those TIPS, you get 50 basis points” of yield, he said.

Mr. Ambachtsheer questioned whether the price of long-term payment certainty from fixed income has become so expensive to make it attractive only to the most risk-averse. In turn, he suggested a portfolio of high-quality dividend-yielding equities could provide yields in excess of fixed income while also providing protection to withstand a great deal of volatility.

“If you want to match (the) cash flows (of pension) promises, then you have to go out and buy a bunch of 2% bonds that match those payment obligations,” Mr. Ambachtsheer said. “It's expensive.”

In a scenario he drew of 2% inflation and 1% real growth — which comes close to today's economy — even in a relatively short term of five years, a return-seeking portfolio of quality dividend-paying equities can decline 20% and still outperform or match a risk-reducing portfolio.

“You can go down 20% and still break even with a risk-reducing bond portfolio” over five years, Mr. Ambachtsheer said.

“Short-horizon payment certainty is a legitimate need and it should be met,” Mr. Ambachtsheer said. “Sometimes that's cheap, and sometimes that's expensive.”

But in the longer term, the compound return of a portfolio of quality stocks is more likely to do better than a portfolio of 2% bonds, Mr. Ambachtsheer said. For bonds, cash flow stays at $2 all the way through. But in the case of equities, you start out on an edge on the yield, which will grow.

In January's Ambachtsheer Letter to clients, he noted: “Given today's equity and bond pricings, bad surprises with major economic consequences for extended periods of time would have to occur for low-risk bond returns to exceed those of a well-diversified portfolio of dividend-paying stocks over the next 20 years.”

In a March letter, Mr. Ambachtsheer said a $100 pool of a returning-seeking portfolio, yielding $4 today with income reinvested, will compound to a $400 pool yielding $16 in 20 years.

By contrast, a $100 AAA-rated sovereign bond with a fixed 2% coupon will compound to only $150.

Strategic Economic Decisions' Mr. Brock said: “The world will now revert to one where shareholders will demand dividends. ... We baby boomers will fire managements that do not return yield. The dividend income from good multinationals that are low in debt is not in fact "risky' like stock prices. This point is rarely made.”

“A pension fund can easily live through ... cycles in stock market values provided that the yield is stable,” he added. “Now, not only will the dividend yield be higher than that of bonds in general, and stable, but also the price of shares will rise over time. So the fund is triply better off than with Treasuries.

“Furthermore, given that (corporate) earnings now come from very diversified sources globally, the income is even more (recession proof) than before,” Mr. Brock added.

“The deeper story here is that government securities — once very "safe' — will be increasingly unsafe as nations become more and more indebted due to baby boomer retirement costs,” Mr. Brock said. “Companies like “L'Oreal (Group), Nestle (SA), etc. will become more geographically diversified and stable. They (will) become safer than governments. I have called this an age of "Alice in Wonderland investing,' when Alice looked into the mirror and saw everything upside down.”

Mr. Paulsen said: “We are starting to desensitize from stories of Armageddon ... (that) were a big boon for bondholders because every time one came, it pushed (bond) yields lower and bond prices up.

“You just aren't getting the same bang (in higher bond prices) for the Armageddon stories we used to get. Take the fiscal cliff ... it didn't do much. Sequester is still out there. Didn't do much.”

Investors are “not rushing to bonds as safe havens as they used to do,” he said.

“Bonds are being priced so far off the fundamental curve right now,” Mr. Paulsen said. The 10-year Treasury bond “is trading at zero percent above the rate of inflation, maybe even negative to the rate of inflation,” Mr. Paulsen said. “The 10-year yield is at 1.75% (now) and the inflation rate is 2% right now. In order to be back to some semblance of fundamental pricing again, the bond yield right now should be 4% at a minimum (including inflation). That's where (bond yield) would normally trade if you didn't have the Fed sitting on it (interest rates) and the fears of Armageddon.”

If the economy improves and Federal Reserve policymakers start to back away from their policy easing, bond yields could double, causing “a major hit to the bond price (and to) bondholders.” Mr. Paulsen said.

“One thing that is keeping yields down is this latent post-crisis psychosis,” Mr. Paulsen said. Investors have “done well” with them and “feel safe with them after what's happened with equities. After they watched equities fall in half in 2008, a lot of people still have decided they aren't going back” to equities.

But that investor allocation “would really change if bonds actually start going down. That would cause (investors) to re-evaluate (their allocation) in a hurry,” Mr. Paulsen said.

The other thing keeping yields low is the Fed's massive purchasing of bonds, Mr. Paulsen said. But the market landscape is changing.

“Economic growth is coming in better than expected, which is bad for bonds,” Mr. Paulsen said. “The Fed is talking more (about) exiting” its low-interest rate policy, which is bad for bonds. And bond yields are really low, and below the rate of inflation already.”

“The risk in bonds is the absolute decline in ... value,” Mr. Paulsen said. “The risk in high-dividend stocks is more that you don't gain anything and you miss out on other (equity) assets going up.”

Every investor should own some high-quality bonds as a protection against recession, Mr. Paulsen said, even though “they pose the greatest downside risk right now.”

In addition, he suggests owning lower-quality bonds, including high-yield bonds, which act more like a higher-dividend paying stock

“I don't think it's a good time to be LDI-ing your portfolio,” Mr. Paulsen said, referring to liability-driven investing. “I think there is going to be a lot of disappointment with the popularity of that approach five or 10 years from now when rates go back up. ... A lot of institutions will question whether it was right to lock that (LDI) in at the point they did.” n