Three months ago, I wrote in “Why Clients Need High Quality Individual Bonds” that we were finding some value in the three- to six-year maturity range. At that time, three-year yields were touching 2.5%, with five-year yields near 3%.
Since that time, rates have risen modestly, as the Federal Reserve became more hawkish in its attempt to contain inflation. It announced a 50-basis-point increase at its May meeting, while hinting further increases were likely to be in 50 bps increments. Currently, we are seeing three-year yields at around 3.0% for A-rated corporates. Meanwhile, five- and six-year yields for these securities are hovering around 4.0%.
Year-to-date, however, we have seen a relatively large increase in yields. For example, two-year Treasurys ended 2021 at 0.73%, and have since exploded 171 bps to 2.44%, five-year Treasurys have increased 142 bps to 2.68%, and 10-year Treasurys are at 2.74%, up 123 basis points year to date. (Fun Fact: This is known as a “bear flattener,” since short-term rates have increased more than long, causing the yield curve to flatten).
During this same time period, the Fed has increased rates by 75 basis points. As a result, it appears that future increases in short-term rates are now adequately reflected in the intermediate portion of the bond market. With no discernable difference between five- and 10-year yields, however, we would not go out too long at this time. Instead, we remain comfortable in the three- to six-year range.
An All-Around Mess
What has made 2022 particularly ugly so far, is that both stocks and bonds have sold off and are deeply in the red year to date. What began as a sell-off in the high-flying sectors of the market (mostly cloud- and crypto-related stocks) quickly spread to the FANGAM stocks and is now catching up to the old-economy stocks in the Dow Jones Industrials. As of this writing (May 26, 2022), the Nasdaq index is down 25.8%, the S&P 500 has fallen 14.9%, the Dow Jones off 10.2%, while the Bloomberg US Aggregate Bond Index is also down 7.9% YTD.
A side-effect of losses in the bond market is that many clients who had been fixed-income only are now willing to add some equities to their portfolio. While this may sound counter-intuitive to us as advisors, we must put ourselves in their shoes. Realize that as interest rates were falling, clients were seeing significant gains in their bond holdings. As 10-year yields fell below 0.5%, they may have expected the paper gains to continue.
An Opportunity to Diversify
The upshot is that the current equity environment is providing an opportunity to diversify those accounts. For clients who are still focused on yield (or cash flow), we are finding opportunity in the recent sell-off.
In general, the same investment advice applies to buying dividend-paying stocks as bonds:
- Be Selective: We are starting to see some compelling equity opportunities that you can afford to average in over time, either by selectively adding new names or buying more shares of current holdings. But don’t try to be a hero and wait for the bottom to put all your client’s money to work. As experienced advisors know, trying to consistently predict the bottom is a fool’s errand.
- Buy Quality: Focus on companies with growing sales and earnings, low valuations, strong balance sheets and low dividend-payout ratios — not just the yield. Strong companies should be better able to make it through a difficult economic environment.
- Diversify: Typically, 5% of equities should be the maximum for an individual name in client portfolios, though you still want to keep the bonds and stocks of a single issuer below 10% of total account value. Diversify across sectors and industries as well.
- Don’t Be a Yield Hog: A dividend yield over 5% should be a red flag. Know what you’re buying, and whether the company is facing any significant challenges in the current environment.
- Monitor: We are in a different economic and market environment than just six months ago. You may want to reevaluate your current holdings if you have not already done so.
- Focus on Total Return: While dividends are great, ideally you want the trifecta: a reasonably high dividend yield, growing payouts over time, and capital appreciation from the stock. Appreciating assets and increasing dividend distributions can help overcome inflation’s impact on the purchasing power of your clients’ portfolios.
While we often utilize individual securities in our client accounts at Heber Fuger Wendin, for the purposes of this article we wanted to highlight a few sectors that may offer attractive opportunities for clients looking to diversify their holdings. The following ETF sectors have been an area of focus for us recently.
Financial sector stocks and ETFs have come under pressure in the sell-off, and some appear to offer good value. For example, the SPDR Financial Select Sector ETF (XLY) is down over 22% from its highs, and near a 52-week low. It has an average P/E multiple of 10.8, and a dividend yield of 1.88%. XLY’s dividend distributions have grown 8.2% annually over the last five years.
Banks should benefit from a rising rate environment, as they are expected to pass along higher rates to their customers, while keeping deposit rates low (the net interest margin). But, if you choose to invest in individual bank securities, be careful of banks with a heavy presence in mortgages, as that sector will likely face dwindling refinancings as rates rise, and home sales may continue to drop.
The Healthcare Select Sector SPDR fund (XLV) has held up relatively well. It’s down “only” 11% and appears to have found support at current levels. Valuations look fair at 22 times trailing EPS. Although the yield here may be modest at 1.46%, it has increased by an average of 10.7% over the last five years. Minimal economic sensitivity has helped keep this sector out of bear market territory so far, and inflation should have a relatively limited impact on it. Remember that many individual pharmaceutical names have higher yields but can experience significant volatility based on news about patent approvals or expirations on their pharmaceutical lineup.
Meanwhile, the SPDR Consumer Staples Select Sector SPDR Fund (XLP) dropped significantly after earnings reports from Target Corp (TGT) and Wal-Mart (WMT) highlighted the negative impact of inflation. While bottom fishing can be fun, we are taking a wait-and-see approach with this sector, as it still appears expensive at 23.6 times earnings per share. It boasts a relatively high yield of 2.4%, but its distributions have grown at a slower 5.5% rate over the last five years and even that growth appears to have slowed recently.
Intermediate bonds and dividend-paying stocks offer opportunities as rates rise. Many clients may not have realized the risks in their portfolio and yet can sometimes be too conservative for their own good. It is our job to point that out. Consider using this period of high volatility to your advantage by repositioning client assets into intermediate bonds and dividend-paying stocks for what may well lay ahead — a period of rising interest rates that will negatively impact the economy.
Christopher Baccella, CFA, an investment advisor with Michigan-based Heber Fuger Wendin, delivers investment management services to the RIA firm’s high net worth and institutional clients. Heber Fuger Wendin has $8 billion in assets under management and has been managing fixed income portfolios since 1934.