‘Safe’ stocks remain risky and volatile in an era of rising rates and yields

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The sectors and securities typically thought of as safe and defensive currently offer little in the way of safety and defensiveness.

Victims of their own popularity, investors have piled into the defensive trade in recent years, inflating valuations on those pockets of the market that have traditionally served as safe havens.

"Everything is a little bit expensive because we've had six years of recovery, but those defensive sectors are egregiously so," said Stephen Lingard, portfolio manager with Franklin Templeton Solutions.

Those sectors are at least as vulnerable as cyclicals to a substantial market downturn, Mr. Lingard said. And even in the absence of a correction, rising interest rates could bring about the same end result – a selloff in defensive stocks, yield-bearing equities and bonds.

Defensive stocks, also called counter-cyclicals, are those less susceptible to macroeconomic fluctuations. They represent parts of the economy that would feature some resiliency of demand in a downturn, such as utilities, consumer staples, health care, telecoms and some real estate investment trusts. The bond market is also generally seen as a lower-risk companion to the stock market.

All of which have been inflated by the demand for safety and the hunt for yield.

Mr. Lingard said his analysis shows that the global telecom, consumer staples and health-care sectors, excluding emerging markets, all trade at about 2.75 standard deviations higher than their 10-year historical averages. By comparison, the Nasdaq index traded at more than three standard deviations higher in 2000 prior to the tech bubble popping, while Japanese equities reached two standard deviations above the norm in 1989 before crashing.

"We're not far away from some of the bubble territory we know well," Mr. Lingard said. "Not to say this is imminent, but when you look at risk-reward, that's not the kind of game we like to play."

What's unusual is that defensive sectors have been outperforming amid one of history's more persistent bull markets. "That really shouldn't occur," said Patrick Horan, principal and portfolio manager at Agilith Capital.

The appetite for safety might be partly explained by investor anxiety lingering from the market crash of 2008-09, as well as skepticism over a tenuous and patchy economic recovery.

More important, paper-thin bond yields have pushed investors into the stock market in search of stocks that behave like fixed-income securities. Defensive stocks and dividend stocks are not synonymous, but there is plenty of overlap between sectors featuring generous dividends and those offering some defensive characteristics.

"In a lot of ways, they're bond proxies," Mr. Lingard said. "As a result, they are extremely well bid."

The Globe and Mail's resident market strategist Scott Barlow illustrated this effect in Canada's market, showing that since 2006, utilities stocks in Canada have grown by 240 per cent, and real estate stocks by 263 per cent, greatly outpacing the broader index at 137 per cent.

Those rate-sensitive sectors have both shown their vulnerability to recent rising yields. The S&P/TSX REIT index has dropped by 8.4 per cent since early February. The S&P/TSX utilities index has fallen by 1.8 per cent year to date.

"Those stocks have benefited tremendously from the low-beta trade," Mr. Horan said. "As interest rates go up, interest in them will go down. They could underperform for years."

The areas of the Canadian market he said he now prefers include export-oriented stocks, such as Martinrea International Inc. and Magellan Aerospace Corp., and technology companies such as Absolute Software Corp. and Sandvine Corp.

The leading catalyst for that kind of rotation would be an extension of the global rise in bond yields witnessed in recent weeks, fuelled by the prospect of the U.S. Federal Reserve finally beginning to raise rates.

Investors need to prepare for an era of rising yields by revisiting what they think of as "safe," said Zachary Karabell, head of global strategy at Envestnet.

"Investors should beware of the fact that there's a lot of volatility in those areas considered safe and boring."