mathew-tillett

As a stock picker, 95% of my time is spent analysing individual companies in order to understand how and why their shares might be mispriced. This is what I enjoy doing most and is also where I think (or hope) that I have some specialist skills. However, I also believe that entire asset classes can be mispriced, particularly relative to each other. Indeed these mispricings can actually be greater than at the individual stock level. Powerful structural forces such as regulations or capital controls can coerce certain groups of investors to buy or sell asset classes en masse causing large movements in price that may not be justified by underlying fundamentals.

One area where I suspect such a mispricing may exist today is in the valuation of “Investment Grade” (IG) corporate bonds relative to the underlying equity.  IG means high quality. Only the most robust business models with entrenched market positions and strong balance sheets achieve IG ratings. Such a rating bestows upon them a lower cost of capital – i.e. they can borrow money at lower rates than other companies. What dividend yield would you expect an IG company to offer? Logically, you might expect it to be fairly low also. You might even expect it to be lower than the bond yield, reflecting the fact that the dividends of high quality companies tend to be very safe and also usually grow over time (unlike bonds, which only offer a fixed coupon payment).

Yet this is not what we see in the real world. In many cases, the dividend yields of IG companies are higher than their long-term bond yields. Take, for example, British American Tobacco, a globally diversified tobacco company with a long history of dividend growth1. It currently pays a prospective 4.5% dividend yield.  The 2026 bond offers a 4% yield2. Even if you assume the dividend never grows again you are still paying over 10% more for the bond coupons versus the dividends. Of course, the bond coupon payment is more secure than the dividend payment, but is this security really worth a premium, especially considering that it will never offer any growth (in contrast to the dividend, which has grown at over 10% per annum over the past 10 years)?

I think this example is reflective of a broader mispricing of risk. Quantitative easing has pushed yields on government bonds down to such low levels that bond investors have been forced to venture further out in the search for yield. As a result, the prices of corporate bonds have gone up driving their yields down. However, there are structural reasons why many of these investors would not consider buying the equity instead. For example, many pension funds have long-term liabilities which they seek to match with assets that offer fixed payments and maturity dates. As a result, they may not consider buying an equity dividend stream instead of the bond, even if it is more attractively priced.

The chart below is a fascinating exposition of how this situation is playing out in the UK market. The light blue bars represent the FTSE UK High Yield Index. The dark blue bars show the universe of companies whose bonds yield over 4%. The chart shows the distribution of these companies based on credit quality, ranging from the highest quality “AAA” down to the lowest quality “C”. (Note: Investment Grade is anything rated above BBB-).

divis bonds

The conclusion from the chart is clear: There are still many equities that offer high dividend yields in the upper end of the IG universe (A – AA) but fewer bonds offering such yields. So, if you’re looking for an attractive income stream from high quality companies with strong credit ratings you are much more likely to find it in the equity market than in the bond market. This suggests to me that the equity of high quality IG companies may be undervalued relative to their bonds. Unfortunately, it doesn’t say anything about absolute value. To assess whether equities are undervalued in absolute terms requires looking at other measures such as replacement cost and long run earnings power – the subject of a future post.

Mathew Tillett

 

1. This is no recommendation to buy or sell any particular security.

2. Source: Bloomberg, July 2014.

3. Credit: Based on the GBP iBoxx IG index with current yield of 4% or more. Also included GBP HY bonds providing more than 4% yield. Distribution based on outstanding notional of bonds included. It should be noted that these bonds are all GBP denominated but not necessarily from UK issuers. Equity: Based on around half of the names in the FTSE Higher Yield index (account for more than 90% of the index weight). Distribution based on weight of names in the index.

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