Is the bond bubble ready to burst?

Will the U.S. Fed raise rates sooner, rather than later, and torpedo the current bond bubble? Some investors are desperately chasing yield in riskier bonds, but that may be insufficient compensation when the next global crisis comes down the pike. Instead, investors should look to companies with a strong track record of dividend growth as a way to satisfy their yearning for yield. Portfolio manager John Stephenson names three U.S. stocks that fit the bill.

The $100 trillion global bond market has been on quite a tear recently as investors lunge for yield. Despite record low rates, income-starved investors have helped propel a strong bull market in bonds, with conservative investments such as the U.S. 10-year Treasury jumping almost 7 per cent in price so far this year and the 30-year bond surging 17 per cent. In total the U.S. government debt has unleashed a massive $660 billion windfall to investors so far this year.

Outside of the U.S., yields have sunk even lower with some $10 trillion of negative-yield debt, including the ten-year notes of Japan, Germany and Switzerland. Many investors have been lured by higher yields in emerging market bonds and in junk bonds.

According to Trim Tabs Investment Research, a firm in Sausalito, California, investors have poured $1.2 billion into exchange traded funds focused on bonds from emerging market countries since June 30. So far in July, investors have also pumped another $2.8 billion into high-yield ETFs that are comprised of junk bonds issued by below-investment-grade companies.

One out of every 14 dollars invested in those two fund categories has been put in play in the past three weeks.

The reason for the rush into riskier bonds seems to be the desperate search for yield. According to Morningstar, the average emerging markets bond ETF yields 3.8 per cent, while the average high yield ETF yields 5.5 per cent. Contrast this with the ultra-safe 10-year U.S. Treasury where investors will earn less than 1.6 per cent.

Researchers Yueran Ma and Carmen Wang of Harvard University, along with Chian Lian of the Massachusetts Institute of Technology, have found that investors aren’t tantalized by risky alternatives until rates fall below three per cent. The lower yields go—the more risk that investors are willing to take.

These ultra-low yields are sending a very gloomy message about the future, as today’s high bond prices and pathetic yields suggest low returns in the years ahead. Investors who purchase these bonds seem to be saying that they aren’t concerned about the possible risk of high inflation eroding the value of their money. Instead, investors seem to feel that we are in a low-growth world where there will be paltry wage growth and weak consumer spending for the foreseeable future.

The reasons for the gloomy outlook range the gamut from an economic slowdown in China, Brexit and the European Union’s uncertain future, as well as weak oil prices and the teetering banks in Italy. Yet in spite of the pessimism, the unemployment rate in the U.S. is down to levels not seen since 2007.

To some, the average yield of 3.8 per cent on emerging market bonds may seem reasonable when compared to the yield on U.S. Treasuries. But this cushion may suddenly become too thin if turbulence starts brewing in far-flung places such as Brazil, Turkey, Russia or other developing economies.

Bill Gross, a widely followed manager of the Janus Unconstrained Bond Fund, calls the current low interest rate environment pure science fiction. “It resembles a financial black hole from which no interest or yield can escape and no further capital gains are possible,” he says.

Investors are overwhelmingly of the view that the Fed is on the sidelines for the foreseeable future and that they will leave benchmark short term interest rates at historic lows. A thirty-four year bull market in bonds has only helped to reinforce the view that rates will never go up. But with everyone on the same side of the boat, a contrarian trade is unfolding, namely that the Fed will raise rates sooner rather than later—torpedoing the bond bubble.

What I Recommend

Investors should be cautious when investing in bonds, particularly high-yield bonds and those of emerging markets. The extra yield you may be picking up to move up the risk curve may not be sufficient compensation when the next global crisis comes down the pike. Instead, investors should look to companies with a strong track record of dividend growth as a way to satisfy their yearning for yield.

When searching for solid dividend paying companies, I believe it is very important for investors to not just focus on yield. Instead, they should search for companies with a consistent track record and superior cash flow with which to support future dividend growth.

In screening for companies that fit the bill, I have taken a look at those that have had no cut to their dividend in the last five years; have had a one-year dividend growth per share greater than the S&P 500; a current dividend yield greater than the S&P 500; a free cash-flow yield greater than the dividend yield; and a dividend payout ratio lower than the S&P 500.

One company that screens quite well on our proprietary dividend screens as well as fundamentally is NextEra Energy Partners LP (NYSE—NEP). The company is a growth-oriented limited partnership formed by NextEra Energy, Inc., which acquires, manages and owns contracted clean energy projects with stable, long-term cash flows. The company owns interests in wind and solar projects throughout North America, as well as natural gas infrastructure assets in Texas.

The renewable energy projects are fully contracted, use industry-leading technology and are located in regions that are favorable for generating energy from wind and sun. I estimate that the dividend should grow at a compound annual rate of more than 12 per cent between now and 2021. The current dividend yield on the stock is 4.3 per cent. I have a Buy rating and a twelve-month price target of USD $37 per share on NextEra Energy Partners LP.

Another company that scores very highly using my methodology is Robert Half International Inc. (NYSE—RHI). Robert Half supplies temporary and permanent, full-time and project accounting and finance professionals; temporary administrative support personnel; information technology professionals; temporary, project and full-time lawyers, paralegals and support personnel; and advertising, marketing, and web-design professionals.

A pickup in U.S. economic activity is the key driver of Robert Half, and with many economists expecting the American economy to grow at a clip of more than 2 per cent over the next year and a half, this is good news. The company has historically outgrown the temporary services industry by a two-or-three times margin. The company has a long history of returning 100 percent of its cash flows back to investors through dividends and share buybacks. The market for skilled workers like the sort that Robert Half supplies remains very tight, and rising voluntary turnover and job openings among professionals is also boosting the demand for professional staffing services. I have a Buy rating and a twelve-month price target of $42 per share on Robert Half International Inc.

Another very solid name that screens very well is KeyCorp (NYSE—KEY), a bank holding company and financial holding company headquartered in Cleveland, Ohio. The company is one of America’s largest bank-based financial services companies, with consolidated total assets of approximately $101.2 billion. Its subsidiaries provide a wide range of retail and commercial banking, commercial leasing, investment management, consumer finance and investment banking products and services to individual, corporate and institutional clients.  Keycorp’s credit quality remains very solid and the company was one of the first to drive the credit recovery train by recognizing and resolving its credit problems earlier than many other regional banks. I have a Buy rating and a twelve-month price target of $14.50 per share on KeyCorp.

The stock market is likely to perform as it has so far this year, namely long periods of stability punctuated by short periods of extreme volatility. With Trump and Clinton squaring off and continued uncertainty in Europe over the implications of Brexit, the best defense against stock market volatility will be to have some good dividend-paying stocks in your portfolio to help you ride out the coming storms.

John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse.” He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or jstephenson@stephenson-co.com.