Increasing bond yields were a key driver (and symptom) of risk sentiment in March. The 10 Year Treasury Yield – which attracted a lot of attention from journalists and market commentators - increased from 1.40% to 1.74% over the month.
Short duration stocks which have strong short-term cashflows and high payout rations, but relatively poor growth profiles are often referred to as “bond proxies”. Typically, the performance of “bond proxies” is positively correlated with bond prices. When yields rise (and bond prices fall), these stocks tend to underperform.
However, in the current market environment where many of these stocks have dividend yields which are significantly higher than bond yields, a 0.34% increase in Treasury Yields to 1.74% is unlikely to materially affect investor sentiment. This was the case in March, with many “bond proxies” in Asia performing relatively strongly.
Long duration stocks, however, are a totally different proposition. These stocks have small cashflows relative to their share prices, but the potential to generate supernormal profits and hence strong future cashflows. When you apply a materially higher discount rate to the cashflows of long duration stocks, the NPV falls sharply. This is potentially problematic for these stocks given they are priced to perfection and a low discount rate is required to justify their extreme valuations.
The Fund has a net long exposure to short duration stocks with high dividend yields. Structural challenges, such as those faced by retail and office REITs, are dealt with via the non-systematic overlay and the fund only has a long exposure to these stocks when the yield justifies the structural risks.
At the other end of the spectrum, the Fund has a net short exposure to expensive high duration stocks, especially stocks where an unjustifiably high growth rate and low discount rate are required to justify their valuations.
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