Bond proxies explained

After many years of Interest rates at all-time lows and investors crowding into equities, back in 2016 one group of equities in particular stood out – ‘bond proxies’.

What is a bond proxy?

‘Bond proxy’ describes equities, such as consumer staples and utilities, with safe, predictable returns and often with yields higher than the bond market.

Why do bond proxies perform so well in a bull market?

Companies holding the bond proxy name tend to generate strong cash flows and high returns on their invested capital. These returns can either be reinvested by the business, used to enhance shareholder growth or used to increase dividends.

Another possible advantage is that they may possess barriers to entry that allow these companies to continually outperform their peers. These barriers may be intellectual property, such as patents, or brands that are difficult to replicate, such as Microsoft, Johnson & Johnson, Nestlé or Unilever.

Another trait shared by many bond proxies is relatively low borrowings. This gives them greater solidity in times of market stress and allows them to make value-creating acquisitions at opportune moments. Take brewer AB Inbev, for example. It has made a string of big acquisitions and built up an unrivalled portfolio of beer brands that is almost impossible to replicate.

Regulator support

Another type of bond proxy stock is a company with solid earnings underpinned by regulation. Utilities are a great example of this: a regulator sets both the pricing and the returns companies can generate over multi-year periods. These companies benefit from steady cash flows and earnings, giving them bond-like properties, although if regulation changes, their existing business model may come under pressure.

Some bond proxy stocks have built up exposure to emerging markets,and can exploit the quicker economic growth in these countries. Unilever, for example, derives around 60pc of its revenues from emerging markets.

The laws of supply and demand also apply to bond proxies. When the availability of something reduces (in this case earnings), the price (valuation) goes up. In some cases valuations become inflated, with price earnings (PE) ratios often in the high 20s or low 30s. After the EU referendum result back in June 2016, when bond yields fell to all-time lows, the share prices of companies considered bond proxies rose sharply.

Impact of political change on bond proxies

However, subsequently bond yields rose back to the levels of early 2016. This was driven by the fall of sterling after the Brexit vote, unexpectedly robust economic growth and low levels of unemployment in the US and the UK.

Towards the end of 2016 we saw bond yields rise more quickly. Inflation expectations prompted a sell-off in government bonds, which pushed the price of bonds down and the yield you can get from them up. That’s because rising inflation makes it less attractive to hold government bonds, which lock investors in at set interest rates.

The solidity, high returns and strong cash flows of bond proxy companies are compelling reasons to own them over the longer term.

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