Download A Solution for Yield-Starved Insurance Companies: Dividend Equities

August 2015
A Solution for Yield-Starved Insurance
Companies: Dividend Equities
Federal Reserve efforts to normalize monetary policy are unlikely to provide
meaningful relief for yield-starved insurance companies. Elusive domestic
inflation and ongoing reflation efforts around the world are likely to continue
weighing down intermediate and long yields. With insurers unlikely to
experience material improvement in income from core bond strategies,
we believe equity income strategies are an attractive complement to fixed
income given the combination of income and return potential.
W. Charles Cook, CFA
Director, Portfolio
Strategist
James Kaniclides, CFA
Senior Portfolio Manager,
Fixed Income Strategist
A Solution for Yield-Starved Insurance Companies: Dividend Equities
Core Bonds and Low Yields
Central banks around the world have implemented extreme
policy measures to foster liquidity and promote capital
deployment in efforts to fuel growth and employment. The
Federal Reserve has been at the forefront of this movement
by maintaining a target policy rate of zero since 2008 and
by pursuing several massive bond-purchase programs over
this period. Growth and inflation have been slow to respond,
which has depressed yield curves worldwide to low - and
even negative - levels of real and nominal interest rates. This
environment has been challenging for insurance companies
that have experienced falling investment yields, given their
large allocation to core bonds.
Exhibit 1: Property and Casualty Companies - Gross Bond Yield (%)
at the historical volatility of bonds relative to other asset
classes, which serves as a reminder of the appeal of core
bonds in supporting claims reserves and the rationale for the
favorable capital treatment.
The Fed’s march toward normalization is unlikely to cause
a departure from this pattern of remarkable stability in
core bonds. Forward rate curves and the central tendency
projections by the Fed suggest a slow pace of rate hikes over
the next few years with core inflation projections remaining
well within the Fed’s comfort zone of 2%-2.5%. As a
result, forward yields reflect a bearish flattening in which
intermediate and long yields are contained.
With the pace and magnitude of rate hikes suggested
by forward curves offering only modest optimism for
improvement in investment income, the search for yield
beyond fixed income will continue. Equities can be
Exhibit 3: Forward Yield Curves (YTM %)
Source: SNL Financial as of 12/31/2014
Core bonds have been a funding source for higher-risk
strategies in an effort to increase yield and return potential.
Nevertheless, core bond strategies remain the dominant
exposure in insurers’ allocations. The important role that
core bonds have in strategic allocations is evident in looking
Exhibit 2: Annual Return (%) - Bonds and Equities
Source: Bloomberg as of 8/14/2015
Source: Barclays, Bloomberg as of 2014
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A Solution for Yield-Starved Insurance Companies: Dividend Equities
important elements in strategic asset allocations given the
attractive risk-adjusted returns and the low correlations with
fixed income. We believe an equity income strategy within
the strategic allocation can help achieve portfolio efficiencies
while also offering incremental yield.
Income Opportunities of Dividend Equities
With global bond yields at historic lows, equities now offer
yields that are as compelling relative to fixed income as they
have been in several decades. Since the inflation-induced
spike in bond yields in the early 1980s, bond yields have
been attractive relative to equity yields. Over the past 50
years, the dividend yield of the Standard & Poor’s 500 Index
has generally been below that of the 10-year U.S. Treasury.
Investors have been rewarded for owning bonds over the
past 30 years, benefiting from high coupon income and a
long period of disinflation in the U.S. and abroad.
Exhibit 4: U.S. Treasury Yield Less Dividend Yield
More recently, however, quantitative easing in the U.S. and
overseas has driven bond yields below those of equities.
This is a global phenomenon, and in most developed equity
markets, dividend yields are close to or higher than bond
yields. In the U.S., the current percentage of companies
with dividend yields above the 10-year U.S. Treasury bond is
approximately 33%, one of the highest levels in more than
30 years (Exhibit 5). Dividends as a source of yield have not
been as competitive relative to bonds in a generation.
With a significant portion of the equity market trading at
greater yields than the 10-year U.S. Treasury, opportunities
for income-oriented investors abound. It is possible to build
a well-diversified portfolio of large, liquid equities with
yields that are above those of bond indices.
Another key benefit is that the income stream of dividends
typically increases over time and has risen approximately
7% a year over the past 35 years.1 As economies grow, so
too will the earnings and dividends of equities, enabling
them to offer attractive prospective returns should the
economy experience periods of rising interest rates, whether
precipitated by stronger growth or rising inflation.
Dividends Drive Returns
Source: Wolfe Research as of 7/31/2015
Dividends have historically represented nearly half of the
return to equities over a long time horizon. Emphasizing
dividend equities, particularly those with high dividend
yields or growing dividends, has historically contributed to
excess returns relative to the broad market. In addition, these
dividend cohorts have tended to exhibit similar or slightly
lower volatility, which has led to better risk-adjusted returns.
Exhibit 5: Dividend Stocks Yielding More than 10-Year U.S. Treasury (%)
Source: Wolfe Research as of 7/31/2015. 500 largest market cap companies.
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A Solution for Yield-Starved Insurance Companies: Dividend Equities
Exhibit 6: Average Annualized Returns of S&P 500
Stocks by Dividend Cohort
proxies,” which tend to perform well as bond yields fall and
perform poorly as bond yields rise, led the equity market in
2014 as global bond yields declined.
Exhibit 8: Relative Returns in a Rising Yield Environment
Source: Ned Davis Research. Monthly Data 1/31/79 – 1/31/15
Importantly, dividend equities generally outperform the
broad market during times of equity-market stress. The
downside capture of equities declines for companies with
high yields or growing dividends. This is an attractive
characteristic for investors concerned about the potential for
capital losses.
Exhibit 7: Downside Capture of Stocks by Dividend
Cohort
Begin
Date
End
Date
3/1986
7/1986
1/1988
7/1989
12/1991
9/1993
12/1995
9/1998
10/2001
5/2003
11/2008
9/2010
6/2012
6/1986
10/1987
3/1989
4/1990
3/1992
11/1994
7/1996
1/2000
4/2002
6/2006
4/2010
2/2011
12/2013
Barclays
Aggregate
Index Return
All DividendPaying Stocks
1.19
5.37
5.41
0.95
-1.28
-3.53
-0.94
-0.81
-0.01
6.07
13.01
-0.94
-0.26
0.02%
4.49
2.77
17.58
-8.60
1.08
-0.42
2.55
4.39
16.04
15.09
32.48
17.62
27.26
10.18%
Source: TBCAM, Bloomberg, Barclays, Ned Davis Research. Periods based on
10-Yr Yield increases of 100 BPS or greater
Fortunately, dividend opportunities come in several flavors,
and strategies can adopt approaches that emphasize cyclical
yield instead of defensive yield, such as that exhibited by the
bond proxies. We believe high-yielding dividend portfolios
can be constructed to produce returns that are competitive
with the broad market by incorporating valuation criteria
and dividend growth in the investment process. These
portfolios offer the advantage of a competitive yield relative
to bond alternatives, with the protection of equities if yields
or inflation rise.
Conclusion
Source: Ned Davis Research. January 1979 – January 2015
Navigating the Risks of Rising Yields
Equities may be impacted by the process of normalizing
interest rates, which arguably supported both bond and
equity valuations. Generally, equities have outperformed
bonds during periods of rising interest rates. If bond yields
rise over the next few years, equities will likely provide
meaningful diversification benefits to portfolios.
As insurance companies continue to search for strategies to
improve investment yield and return, we believe it is critical
to partner with an investment manager that can help design
and implement custom solutions to meet these investment
needs. In our view, the manager should have experience
and expertise in managing core bond strategies that address
the liability, regulatory and tax needs of insurers’ while also
offering counsel and capabilities that extend beyond fixed
income. While core bonds will likely continue to be a large
and essential component of insurers’ asset allocations,
diversifying into strategies beyond core fixed income can
enhance income and return potential. We believe equity
income strategies are an attractive complement to core fixed
income and should be considered in an insurance company’s
strategic asset allocation.
The recent period of unprecedented low interest rates,
combined with bouts of risk aversion caused by global
growth concerns or geopolitical worries, resulted in relatively
high valuations of some dividend investments, such as
utilities and real estate investment trusts. These “bond
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A Solution for Yield-Starved Insurance Companies: Dividend Equities
End Notes
1. Wolfe Research
Disclosure
Any statements of opinion constitute only current opinions of The Boston Company Asset Management, LLC (TBCAM) and Standish Mellon Asset
Management Company LLC (Standish), which are subject to change and which TBCAM and Standish do not undertake to update. Due to, among other
things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors.
This publication or any portion thereof may not be copied or distributed without prior written approval from TBCAM and Standish. Statements are correct
as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances
in which such offer or solicitation is unlawful or not authorised. The information in this publication is for general information only and is not intended to
provide specific investment advice or recommendations for any purchase or sale of any specific security.
Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been
independently verified by TBCAM and Standish. TBCAM and Standish make no representations as to the accuracy or the completeness of such
information.
Listed securities are being presented for illustrative purposes only. This is not a recommendation to buy, sell, or hold these securities.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
About Standish
Standish is one of the largest fixed income firms dedicated to serving the needs of sophisticated institutional investors. Our
investment process strives to capture relative value opportunities created by market inefficiencies. We use both proprietary
research to seek new and changing sources of excess return and a mix of qualitative judgment and quantitative tools to
formulate and implement our investment views. Our strategies reflect expertise in specific market sectors and also span the
global fixed income markets. We can design innovative solutions to satisfy the most pressing needs of investors in today’s
difficult market environment.
About The Boston Company
The Boston Company Asset Management, LLC, is a performance-driven active equity manager. We build portfolios that are
rooted in fundamental research, bottom-up stock selection, macro perspectives and risk controls appropriate for our client
base. We are dedicated to fostering long-term, solutions-based relationships with our clients and earning their confidence
through the consistent delivery of alpha across a wide range of equity offerings. All of our strategies, including traditional
long-only and alternatives, are implemented with consistency and discipline, leveraging more than 40 years of history in equity
investing. Our investment performance is based on a time-tested approach, coupled with the deep, broad-based experience of
our investment professionals.
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About the Authors
W. Charles Cook, CFA
Director, Portfolio Strategist - The Boston Company Asset Management, LLC
Chuck is a Portfolio Strategist for The Boston Company, primarily focused on communicating the firm’s
strategies from an investment perspective to the BNY Mellon Wealth Management group. Before joining
The Boston Company, Chuck spent 21 years at Standish Mellon Asset Management, where he served
both as Senior Global Strategist and Director, Global/International Fixed Income. Previously at the
firm, he held positions of increasing responsibility while gaining experience in global fixed income
portfolio management, derivative strategies and currencies. Prior to that, he worked at State Street Bank & Trust Co. as a
portfolio accountant. Chuck earned a B.S. in Business from Lehigh University and an M.B.A. with a concentration in Finance
from Northeastern University. He holds the CFA® designation.
James Kaniclides, CFA
Senior Portfolio Manager, Fixed Income Strategist - Standish
Jim is a Senior Portfolio Manager and Fixed Income Strategist responsible for managing high
grade multi-sector fixed income portfolios for insurance clients. Jim is also a Co Chairman of
the Crossover Investment Committee that seeks to optimize returns for tax sensitive clients.
He joined the company in 1998 from Citizens Bank, where he conducted quantitative
research in the Treasury Group and managed the Bank’s liquidity positions. Prior to that
Jim was a Bank Examiner at the Federal Reserve Bank of Boston, where he specialized in reviewing asset/
liability management and capital markets activities of banks and bank holding companies. Jim has an M.B.A.
from Northeastern University, a B.A. from Ohio University, holds the CFA® designation and has 21 years of
investment experience.
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