Wednesday, September 7, 2011

Investing in Times of Low Interest Rates

The 10 year US Treasury note ended yesterday yielding 1.94%. The last time yields were this low was 1950.

Although I still believe that we can avoid Japan's fate of the past two decades (sluggish economic growth and massive deflationary pressures) it is worth considering what actions, if any, investors should be taking if we truly are evolving towards Japan.

As a reminder, Japanese interest rates have languished below 2% for most of the past 14 years. And while there have been periodic rallies in the Japanese stock market, the Nikkei 225 now stands at less than a quarter of the peaks achieved in 1989.

This is the question raised in the Financial Times this morning:

"It is decision time for investors," says Rod Davidson, head of fixed income at Alliance Trust Asset Management in Edinburgh. "If you believe in a Japan-style situation almost all bets are off. Equities suffer, corporate credit widens and you would want to own long-dated government bonds. But there are question market over even that as you start to worry about the solvency of governments."

And yet, if one looks at the Japanese stock experience, not all sectors do poorly when yields are falling.

For example, utility analyst Hugh Wynne of Bernstein wrote a piece last year where he analyzed the performance of regulated utility stocks in Japan versus the broader market averages over the past two decades.

What he found was that while the Nikkei produced negative total return of -29% from 1990 to 2010, Japanese utility stocks returned a positive +16% for the same period.

Mr. Wynne went on to analyze the performance of U.S. regulated utility stocks during periods of declining inflation and falling interest rates, and the results mirrored the Japanese experience: namely, utilities offered positive real returns to investors during periods when other sectors were suffering.

It seems logical that other areas would also be attractive to investors that are looking for income. Stocks in sectors like consumer staples and health care offer very attractive relative dividend yields, yet many are trading at low valuations.

For investors not worried about "beating an index" like the S&P 500, stocks like Bristol Myers (dividend yield of 4.5%) or Procter & Gamble (dividend yield of 3.4%) might make investment sense.

Again, I do not believe we turning into Japan, but even if my optimism is misplaced there still seems to be opportunities to add value in dividend-paying stocks.