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Effects of low rates
Interest rates in the developed world are likely to remain at
ultra-low levels for a prolonged period
This will boost the income attraction of equities…
…and will enable some companies to reduce borrowing costs and
increase profitability
Playing the yield
We have argued for some time that in the current
ultra-low interest rate environment, investors will
increasingly see yield as a reason to buy stocks.
Across much of the developed world equity yields
look very attractive relative to the yield available
on both government and corporate bonds. In
addition, dividend-paying stocks have the added
advantage of acting as a hedge against inflation and
also have the potential for upside if earnings grow.
Of course, whilst the attraction of dividend yield
is clear, it is important to remember that, unlike
coupons on bonds, dividends are not guaranteed.
We must therefore also consider whether the
current level of dividends is sustainable. If
companies must pay out a large proportion of
their earnings to sustain their dividends then the
risk of cuts is obviously higher.
Charts 1 and 2 below show the trailing payout ratios
for the US and European markets respectively. As
could be expected these rose sharply during the
recession as earnings fell faster than dividends were
cut, but they have since returned to much more
reassuring levels. In the US in particular the payout
ratio is approaching a record low, although it should
be noted that this doesn’t take into account share
buybacks which have risen considerably over the last
30 years. In Europe, where the rebound in earnings
growth hasn’t been as strong, the payout ratio is still
back below its long-term average.
The picture is equally encouraging when we
consider individual stocks. In table 3 we screen for
companies from the MSCI All Country World
universe that offer both high yields and sustainable
dividends. Specifically we look for companies
with a market cap greater than USD5bn, a dividend
yield greater than the yield on 10-year US
Treasuries (2.9%), potential for both dividend and
earnings growth, and a relatively low payout ratio
which is no more than 10% higher than its fiveyear average. We show the top 30 stocks ranked by
their 2010 dividend yield from the 113 companies
that meet the requirements.
Unsurprisingly the screen throws up many names
from the high-yielding telecom and utilities
sectors. It also includes a number of European
insurers – a sector highlighted by our analysts as
being a key beneficiary of this theme.
Other yield plays
Basic dividend yield is the most obvious way to
find yield in the current environment, but there are
some other attractive angles that are worth
considering. In particular we would highlight
interesting opportunities in REITs and in
preference shares.
REITs are legally obliged to distribute a large
proportion of their earnings in order to maintain
their status and so naturally offer attractive yields.
Indeed, despite having outperformed the wider
market since late 2009, at 4.9% the MSCI All
Country World REIT index still yields
considerably higher than US Treasuries (Charts 4
and 5). In Asia, for example, our analysts like
Hong Kong’s Link REIT (823 HK, OW,
HKD24.35, TP HKD28.50), which has an
indicative yield of 4.3% as well as growth.
Preference shares represent a hybrid between equity
and debt. They pay a regular specified dividend and
rank higher than ordinary shares in the case of
liquidation, but usually carry no voting rights.
Given this status, where they are more risky than
debt but don’t get the benefit of price appreciation
like normal equity, preference shares often yield
more than both. The current dividend yield for the
S&P US Preferred Stock Index is 7.3% compared to
a yield on the S&P500 of just 2%.
It should be noted that the majority of preference
shares are issued by banks (over 80% of the S&P
index) as they can be included in Tier 1 capital
ratios and are often a cheaper form of financing
than ordinary shares. However, the relatively few
non-financial preference shares that are available
also provide attractive yields.
Falling borrowing costs
On top of the dividend yield story, low interest
rates are likely to provide further support for
equities through lower borrowing costs. Many
companies should be able to refinance their
activities at lower rates and therefore increase
margins and improve profitability.
In the US, corporate bonds currently yield around
3% (chart 6), whereas the average effective
interest rate being paid by non-financial
companies is 5.1%. If all non-financial corporate
debt were refinanced at the lower rate, profits
would rise by almost 10%. If, more realistically,
only short-term debt were refinanced then the
aggregate level of profits would rise by 1.5%
In Table 7 we screen for US non-financial stocks
that could potentially benefit most from these
lower costs. To do this we identify those stocks
which have an effective interest rate (interest
expense/total debt) which is higher than the yield
on a five-year corporate bond with an equivalent
rating. We use the most recent interim data
(annualised) in order to capture any refinancing
that may already have taken place this year. The
table is ranked by the impact that refinancing all
short-term debt would have on 2010 net income
and only the top 30 companies are shown.
Obviously, whether or not these companies are
willing or able to refinance their debt will be
determined by many other company specific
factors. However, this screen should provide a
useful starting point for further analysis.
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