Richard Holland

The bond market for Treasuries has been in an astonishing 32-year bull market, outperforming corporate, high yield and emerging market bonds along the way. However, the sustainability of treasury bonds’ performance has been called into question as early as 2009, and the voices proclaiming that the ‘bond bubble’ is about to burst are as loud as ever. As a result, it is worth exploring whether utility stocks provide a suitable replacement to diversify portfolios.

In general, an investor holds bonds in their portfolio for 2 reasons. Firstly, to obtain a fixed-income stream that typically increases as they reach retirement age in order to replace their wage. According to Vanguard, bonds should represent around 10% of your portfolio up to the age of 40, whereby it should then increase steadily to around 70% at the age of 70. Secondly, bonds are used to hedge against the volatility of equities, which is why Vanguard would always recommend having at least 10% of your portfolio in bonds, regardless of your age. To illustrate how bonds and equities tend to move in opposite directions, U.S. stocks returned -37.0% while U.S. bonds actually rose by 5.1% during the financial crisis in 2008.

Simply put, a bubble can be defined as when an asset trades far above it’s true value for an extended period of time and proponents of the ‘bond bubble’ theory attribute quantitative easing (QE) as the cause. After the financial crisis, Central Banks printed new money and used it to buy bonds, pushing up fixed-income prices in the process. The price of bonds was then exacerbated by private and institutional investors, who ploughed $375bn into bonds in 2016 alone, desperately searching for yield in the bear market. In fact, such was their desperation that yields even became negative for German and Japanese government bonds.

Now, many Central Banks have changed course to unwind their QE programmes and investors fear heightened volatility, falling bond prices and even a bond market crash as a result of interest rate rises. The assumption is that once interest rates rise, they will do so relatively quickly which will remove the artificial downward pressure of QE on treasury yields, causing the yields, in theory, to rise sharply as bond prices fall. To give you an idea of the scale, the UK’s total QE programme equates to £435bn of bonds and the U.S. Federal Reserve currently has a balance sheet of $4.5tn. According to a July poll of 207 investment professionals carried out by Bank of America Merrill Lynch, a crash in the global bond market is the biggest tail risk for markets and in the same survey, 55% of the fund managers had already reduced their holdings of bonds.

Therefore, with fund managers selling their bonds, where should they put this capital?

One very plausible option is utility stocks because they achieve the same key objectives as bonds in the short-term and avoid any volatility in the bond market. For my analysis, I have looked at 4 of the UK’s largest utility stocks: National Grid plc, SSE plc, Severn Trent plc and BP plc.

One of the main aims of bonds, is to provide a constant income flow and the data indicates that utility stocks dividend yields were actually far superior to gilts. As of 2017, National Grid, SSE, Severn Trent and BP had dividend yields of 5.39%, 6.57%, 3.84% and 5.87% respectively. When you compare this to the yield of the UK’s 10-year gilt, which stood at a measly 1.32%, utility stocks look very attractive indeed.  Furthermore, utility stocks are often used as a hedge against equity volatility because they typically have a beta coefficient of less than 1. SSE plc and National Grid plc have beta values of 0.59 and 0.74 respectively, whereas the largest U.S. utility company, NextEra plc, has a beta of 0.31. Although all 3 of these stocks move with the market, they will act to dampen any market volatility on your equity portfolio because they are defensive securities.

What’s more, the capital return on your investment is often far greater with utility stocks when held for the long term. To compare, if an investor bought a 10-year gilt at issue for £100, they would only receive £100 at its maturity, plus the interest payments. Conversely, had you held £50 of shares in each of National Grid and SSE over a similar 10-year period, from 1997-2007 or 2008-2017, the initial £100 would be worth £263 and £137 respectively, representing capital gains of 163% in the bull market and 37% in the bear market.

Overall, there is a strong divide amongst commentators over the reality of a bond bubble, but influential figures have come out publically in favour of the issue. The former Chairman of the U.S. Federal Reserve, Alan Greenspan, recently stated that “we are experiencing a bubble, not in stock prices but in bond prices”. Consequently, utility stocks represent a useful short-term investment strategy to reduce exposure to volatility in the bond and equity markets, with their capital value widely anticipated to grow alongside the bullish equity markets.