Last time we wrote about how the 60/40 asset mix needs to be re-thought in a world of negative sovereign yields and skinny coupons in the corporate world, noting that it was born of the same era that led us down the nefarious path of low fat/high carb diets. This time, we take the discussion a bit further.

 

Let's say we were thinking about a Utility (hereafter "Ute" or "Utes") stock in the context of a bond. The thesis for owning a bond is the cash flow it provides and in the case of an investment grade bond, the high likelihood that we ultimately get paid back. Stocks do not possess this "guarantee" on payback, nor are dividends guaranteed (they can be cut or discontinued entirely), which is why they are fundamentally more risky than bonds. At least that's what we have been taught. With that in mind, let's look at a table and then discuss:

What have we done? We have taken the S&P/TSX Utes sector and looked at monthly rolling 5-year and 10-year compounded returns going back 40-years (beginning December, 1979). This generates 418 different 5-year holding periods and 358 10-year holding periods. As you can see, negative outcomes are possible - there have been twenty-three negative 5-year holding periods (about 6%) and three negative 10-year holding periods (about 1%). In other words, you can end up with less money than you originally invested. Of course, we are ignoring the dividends that Utes pay, so let's look at the same data, but this time view it through the lens of total return (we will assume that dividends are reinvested in the Utilities index):

Okay, so now we have completely removed negative outcomes from the data. In fact, our worst 5-year compounded total return would have been ~+2%, which is not that far off from what we can currently get from a 5-year investment grade rated corporate bond, while our worst 10-year compounded total return would have been ~5%, which is similar to what we could get from a sub-investment grade (aka a high-yield bond) bond. And these have been our worst experiences for Utes over the past 40-years. Let's summarize the data in a neat chart:

So, essentially, over the past 4-decades, you had a 78% chance of generating a total return of between 5% and 15% per annum on a 5-year holding period basis and a 93% chance of doing the same on a 10-year holding period basis. History is, of course, not a guarantee of anything that is to come in the future, but it does present us with some pretty compelling math for favorable outcomes.

 

Okay, now let's pivot to a cash flow analysis: let's look at the cash flow from a corporate bond over the next 10 years at a yield of 2.5% when compared to a Ute stock that yields 4.5% and grows that dividend at mid-single digits.

Okay, so what did we do here? We imagined one invested $1 million in a 10-year corporate bond at 2.5% and this generated cash flows of $250k over the 10-years. On the other side, we bought a Utility stock with a 4.5% yield and 5% dividend growth, which we could pretty easily find. However, instead of buying $1 million of it, we bought just enough to match the cash flows of the bond.

 

In other words, we would need to invest only $442k in the Ute in order to match the $250k of cash flow from the bond over the 10-years. This leaves us with $558k to invest in whatever we like – government bonds (is a position 44% invested in a Ute and 56% invested in government bonds lower risk that 100% invested in a corporate bond – I do not profess to know the answer, but it’s an interesting question) or another corporate bond (maybe something riskier and high yield) or a growth stock or whatever.

 

But a fundamental question here might be – is $1mn invested in a 10-year corporate bond more or less risky than $442k invested in a Ute stock for 10-years?

 

Okay, let’s rewind now and think of this another way. Let’s again take our Ute and think about a bond. But this time, we are investing the full $1 million in the Ute. What if we were offered a bond that matched the total cash flows of the Ute over the 10-years? Okay, let’s first look and then comment:

Here we would need the bond to yield just above 5.66% to match the Ute. The question might be – what kind of risk would you be willing to tolerate if you were presented a 10-year bond that yielded 5.66%? Now, answering this question poses some challenges as the only thing in fixed income land we can find that yields close to this would be preferred shares, which we can probably all agree, at least in the case of Canadian rate resets, are of a significantly greater risk than a Utility stock (no liquidity + short 5 year GoC + credit risk = riskier than a conservative stock).

 

On the corporate side, we are probably looking at something in the B or low BB range. Let’s use for our purposes a March 2026 Russel Metals bond that currently yields 4.96%. It’s not quite the duration we need, but it’s also about 70 basis points shy of the yield we need, so let’s imagine if this bond went 3-years longer, it would yield 70-basis points more to compensate us for the added duration risk.

 

Now, do we take on less risk in the Russel bond than we do in the generic Ute stock? Russel can obviously default, but the Ute stock can also decline in value (although, as we noted above, history would suggest that this is a very low risk event), We would argue that the answer to this one is pretty simple –  most people would not view the 10-year Russel bond as a lower risk investment than the Ute stock.

 

And this is before we bring taxes into the discussion. Let's add this to our table:

Here, because of the impact of taxes on bond cash flows, we have knocked down our first scenario to ~$336k invested to match the after-tax cash flow – that leaves us with ~$665k to invest elsewhere. In the second scenario, we can reduce our investment to $762k to match the high risk bond, giving us a ~$238k buffer.

 

So, we think the argument comes down to a few questions:

• What is riskier - $1 million in a corporate bond for 10-years or ~$440k in a Ute stock with a 4.5% yield and 5% annual dividend growth?
• What is riskier - $1 million invested in our Ute stock or $1mn invested in a 10-year B/BB corporate bond yielding 5.66%?
• If taxes are in play – does the even more compelling math push it over the edge (if it wasn’t already)?

Bottom Line: I think these are ultimately somewhat rhetorical questions as the answers seem quite evident. Again, history may prove to be a poor guide, but the buffer provided by the yields (and growth in yields) on Utes (or other high dividend, relatively defensive sector stocks) makes for a pretty compelling investment driver in our view and a further rethink of the 60/40.