Rising bond yield environment
We are in an environment of rising bond yields. To combat inflation, the US central bank or US Federal reserve has just approved its third consecutive interest rate hike of 0.75% to a rate of 3.25% and signalled additional large increases at upcoming meetings. The Fed’s dot plot which is the central bank’s means of signalling its outlook for the path of interest rates has a median projection of 4.4% by the end of 2022 and 4.6% by the end of 2023.
Market watchers believe that about 1.25% of hikes will be approved in the next 3 months.
The latest Singapore 6-month T-bill earlier this month yielded 3.32%, the highest this year and up from merely 0.48% in January 2022. Likewise, the Singapore T-bill with a 1-year maturity has seen rising returns from 0.75% to 3.19%.
Meanwhile, the most recent issuance of two-year SGS bonds offered a coupon rate of 2.7%, while the five-year equivalent issued earlier this month had a return of 2.92%.
The upcoming Singapore Savings Bond (SSB) issuance for October 2022 is also providing a 10 year average return of 2.75% (being the average of the figures in the table below). This means that investors who purchase the SSB has a floor return of 2.6% for the first 3 years and will see coupon payments increasing over time to 2.99% in the 10th year.
Likewise, corporate bonds have seen increased yields. Frasers Property recently launched Singapore’s first corporate green retail 5 year bond at a 4.49% interest rate. The offer was oversubscribed, and Frasers Property upsized its offer by nearly 20%.
With further interest rate hikes, future bonds issuances will be offered with higher interest rates.
Decreasing corporate profits (and dividends)
We are in an environment where many companies face decreasing profits due to slowing growth and higher inflationary pressures. With decreasing profits, companies will inevitably be able to pay out less dividends and lowers yields for investors.
Decreasing profits and dividends puts pressure on share price and generally would cause share prices to fall further.
Considerations for investing in bonds
1) Invested capital is secured
The Singapore government bonds are perceived as risk free, which is the assumption that the rate of default is zero. In the short term, it is unfathomable for such bonds to default.
As shown in the table above, Investment grade bonds on average have a 0.1% chance of default over 1 year and a 2% chance of default over 10 years.
Although bond prices do fluctuate based on the prevailing interest rate, Investors will be able to secure their principal upon maturity should there not be default.
2) Certainty of coupon payments
The coupon or interest to be paid has been stated at inception. Hence the yield could be viewed as certain.
3) Higher interest rates
Investors should take note that with another 1.25% of interest hikes being priced in, upcoming bonds may very well provide higher returns.
If this happens, the market value of existing bonds will fall and investors may have to sell these bonds at a loss should they not be able to wait until maturity.
Considerations for investing in stocks
1) Inflation hedge
Although there is no guarantee on yield as companies do cut dividend when profits reduce, stocks are also a better inflation hedge over the longer term. This is because when companies are faced with higher costs, they inevitably have to raise prices and pass the costs on.
2) Potential capital gain
Although there is a risk of capital loss, with higher revenues and profits over the longer term as a result of inflation and company growth, share prices also naturally increase.
Margin of safety is essential for investing in stocks.
As bond yields is likely to go higher while dividend yields can go lower in the near term, a margin of safety is essential for investing in stocks in such an environment.
There are essentially two broad types of dividend paying stocks:
- Stocks that are priced based on its yields (e.g. REITs)
- Stocks that growth focused provide for some dividends based on excess capital (e.g. Banks)
For stocks that are priced based on its yields, investors demand a yield premium above bond yields due to the higher risk profile. Referring to the chart below, the FTSE ST REIT Index currently has a yield spread of 275 bps or 2.75% above the SG 10y benchmark government bond yield.
This means that with the SG 10y benchmark government bond yield at 3.2%, the FTSE ST REIT Index is currently yielding about 5.95%.
The questions at hand are:
- With a potential 1.25% interest rate hike by the US, would investors demand the same yield spread?
- If so, will the FTSE ST REIT Index’s yield increase to 6.2%?
- How would REITs deliver such a yield?
It would have to either be from increasing profits or lower share prices. Increasing profits is a tall task in the current economic environment, it seems like the only option is for share prices to fall.
For stocks that are growth focused and provide for some dividends based on excess capital, while the dividend yields may not be much higher or maybe even lower than bond yields, investors should consider the potential capital upside should these companies be able to deliver on its growth plans.
Personal finance decisions
1) Allocation profile is important
Risk management is crucial in such times. A balanced approach may leave upside on the table but also minimises the downside risk.
When investing into bonds, the time to maturity and the potential downside should be taken into consideration.
When investing into stocks, there is a risk of the share price falling much lower, even for the best of the blue chips. But stocks will likely be a much better inflation hedge in the longer term.
2) Capital preservation is key to survival
Capital preservation is key to living to fight another day. Investors should not invest more than they can manage with. It is important to hold cash and cash equivalent assets in these times.
So should you buy dividend stocks when bond yields are more than 3%?
The short answer is Yes. While bonds provide for a certain level of interest payments, stocks are a better inflation hedge. Where stocks are valued based on its dividend yield, a margin of safety is important as bond yields are expected to be higher in the near term. For stocks that are growth focused with some dividends, investors will have to assess the company’s merits.
Before making a decision, investors will also have to take consider a margin of safety before investing and personal finance decisions such as capital allocation profile and preservation.