Who Wins in a Rising Rate Environment? | American Funds

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August 2015

Who Wins in a Rising Rate Environment?

“Most people don’t think about technology as a high-yielding sector, but it really is. Today, many technology companies are highly committed to not only paying a dividend but growing that dividend in line with or faster than earnings.”

— Hilda Applbaum

Hilda L. Applbaum Portfolio Manager San Francisco office 30 years of experience (as of 12/31/16)
Portfolio manager Hilda Applbaum discusses income investing

With central banks around the world aggressively suppressing interest rates, the challenge of finding reliable income-producing investments has never been greater. Few investors are more familiar with this dilemma than portfolio manager Hilda Applbaum, the principal investment officer of The Income Fund of America®. In this conversation, Hilda shares her perspective on:

  • Income-oriented investing in a market where the prospect of higher rates looms large
  • The emerging role of information technology companies as high-quality dividend payers
  • The sustainability of corporate profits and expectations for P/E expansion
  • Finding income opportunities in an aging bull market

How are you thinking about The Income Fund of America’s strategy as the Federal Reserve contemplates raising short-term interest rates?

I wish the Fed would just get on with it and raise rates. This period is reminiscent of the “taper tantrum” in 2013, when the anticipation of the Fed’s decision to wind down its quantitative easing program was worse than the actual event. It’s time for the Fed to move off the zero-bound interest rate policy. The economy is in reasonable shape and it makes sense for central bank officials to signal that they are confident the economy will continue to improve, at least at a modest pace.

What is your outlook for the fund in this environment?

I’m feeling good about IFA. Our bond market exposure is near its lowest level ever. That is partly due to the anticipation of rising interest rates, but it’s really more a reflection of how little yield the bond market offers, and how well those markets have done for north of a decade. The low yields on Treasuries, agencies and other investment-grade bonds are actually detrimental to our shareholder payouts. In the case of high-yield bonds, they are still additive to our income, but our high-yield exposure is about half what it was at its peak. That reflects the fact that high-yield bonds have done exceedingly well, and also that we are feeling good about our equity positions. Our equity portfolio managers are not short of investment ideas. The fund has been attracting inflows and we have been able to quickly and enthusiastically put money to work, particularly in the equity markets. So I am quite comfortable with the economic outlook.

How do you think about income-oriented stocks in a rising rate environment?

Different areas of the income market are susceptible to rising rates in different ways. Real estate investment trusts and utilities are more vulnerable to rising interest rates, and that is why those sector exposures are near historic lows in the fund. Those stocks are also trading at high valuations after significant expansions in their price-to-earnings ratios. In fact, by historical standards, their yields are somewhat low relative to their own history — although they are not low relative to the interest rate environment.

But then take telecommunication services, particularly in Europe — that area has not done as well over the last 18 to 24 months. Valuations are not at historical highs, and yields are historically high relative to interest rates, so telecoms have not benefited the way utilities and REITs have. However, the sector can provide both income and a defensive characteristic that the others may not.

Where do you stand on the technology sector as it relates to income?

Most people don’t think about technology as a high-yielding sector, but it really is. When I started with this fund, we had no technology holdings because none of those companies paid dividends. Today, many technology companies are highly committed to not only paying a dividend but growing that dividend in line with or faster than earnings, and the sector represents one of our largest exposures.

Are there types of technology companies that are more or less attractive to income investors?

“New technology” companies — or companies that think they are new technology — are terrified of paying a dividend because they think it signals a lack of growth. That mindset tends to lead them to make poor capital allocation decisions. Conversely, what we’ve seen from “old tech” — companies such as Microsoft, Texas Instruments, Analog Devices and Intel — is a strong sense of capital discipline. They know that they have an obligation to pay a dividend to shareholders. That hones them in on how to spend their capital, and I think it makes them better capital allocators.

What is your outlook for equities?

Equities should do well generally against a backdrop of a reasonably growing U.S. economy and quantitative easing in Europe, even though we are six years into a bull market. Tough decisions that have been made by some countries and companies in prior years will begin to shine through in terms of better earnings and a better environment for consumers. So I am feeling rather reasonable about both stocks and bonds, but I am more excited about stocks on a selective basis.

In a Low-Yield Environment, Income Stocks Remain in Demand

Heading into the sixth year of an equity bull market, U.S. stocks appear expensive in most sectors. Valuations for traditional dividend-paying sectors, including basic materials, consumer staples and utilities, are high both on a relative and an absolute basis. A notable exception is the telecommunications sector, which hasn’t benefited quite as much from the global search for yield.
Source: FactSet. As of 5/29/15.

How would you describe The Income Fund of America?

The Income Fund of America is a conservative fund that helps investors stay the course in down markets, which is important in helping them achieve their long-term goals. We think about IFA shareholders as folks who need income and capital preservation. Over the long term, IFA has provided a predictable, steady stream of income, along with good total returns. And it has achieved these objectives in a low-volatility manner. I liken the fund to the fable of the tortoise and the hare: it is slow and steady.

Do you think about this differently in IFA versus, say, American Balanced Fund®, which you also manage?

Yes, I do. The bond component of AMBAL is an investment-grade bond portfolio and it is there to provide defensive characteristics. In The Income Fund of America, the bond portfolio has multiple objectives, particularly regarding high-yield bonds, which are more akin to equities than either U.S. Treasuries or other high-quality bonds.

Both IFA and AMBAL are conservative funds. If you examine their track records, returns and volatility profiles, you would probably say they have much in common but they get there very differently. AMBAL has what I would call a higher-octane equity portfolio. The stocks are more growth-oriented, and they are not required to pay a dividend. But working counter to that is a very high-quality bond portfolio.

Some of IFA’s defensive characteristics come from its stock holdings, not just its bonds. Every stock that is purchased must have a minimum yield, so each company has to have an eye on capital allocation and dividend payments. That provides for a much more defensive, less volatile type of equity investment. On the other hand, because of the yield requirement, The Income Fund of America owns high-yield bonds, which very often behave like equities in both rising and declining markets.

Corporate profitability in the U.S. is at a 25-year high and much of it has come from lower input costs. Do you think this is sustainable?

In addition to input cost benefits, companies have made gains in other ways and many of these gains should be very long-lived. They include technological advancements and industrial automation that will serve the companies well in the future. I think we are only midway through the game. For example, there are many businesses that have yet to take full advantage of industrial automation. Different companies are in different places on the adoption scale, so I think that trend can help fuel continued profitability.

Corporate Profits Are High, But Opportunities for Growth Remain

While U.S. corporate profits appear to have peaked in recent years, there are still plenty of opportunities for productivity gains and profit growth. The United States, for instance, remains in the middle of the pack when it comes to the global use of robotics in manufacturing, leaving lots of room for improvement versus world leaders such as South Korea and Japan.
Left chart source: U.S. Commerce Department.

Right chart source: International Federation of Robotics as of 2013.

I’m based in San Francisco, with Silicon Valley not far away, and it’s quite staggering to see such a large number of start-up companies and some of the amazing new technologies being developed. That should help with productivity. When it comes to the use of robotics in the U.S., we are quite low on the totem pole compared to other countries. So there’s still a long runway for productivity growth, but we are six years into a bull market and, at some point, there will be some form of consolidation. That’s healthy.

What are some of the things that concern you at this point in the market cycle?

One thing I am looking at more closely now is releveraging. While I’m not panicked about a leverage event, I am concerned that companies late in a recovery period tend to take on more debt under the assumption that the growth they experienced earlier in the recovery is going to continue. I think that’s an unrealistic assumption. In addition, interest rates are so low that I think some companies just can’t resist taking this debt on their balance sheet. We have seen quite a lot of M&A activity and one does have to wonder about the wisdom of all of those acquisitions. Will they actually produce the kind of payoff that companies are modeling when they take on that debt?

How are you thinking about consumer-related stocks in the fund?

Our largest consumer-related exposures are in tobacco and beverages, and we continue to like those industries. Those companies know how to manage modest to even declining top-line growth through increased cost savings and increased operating leverage. They have produced dependable earnings growth as well as strong and growing dividends.

What is your outlook for the health care sector?

We continue to be excited about pharmaceutical investments. People tend to talk about “old pharma” and “new pharma” in the same way that they talk about “old tech” and “new tech.” But some of the large pharmaceutical companies are involved in producing cutting-edge treatments. One area that we are very excited about is immuno-oncology, which harnesses the patient’s own immune system to treat certain cancers. It looks like the large pharmaceutical companies will be the first to have these drugs approved for limited use. We find them interesting because they are good dividend payers trading at attractive valuations.

Key Takeaways

  • Don’t fear rising interest rates; they reflect improving U.S. economic growth
  • Large technology companies have emerged as solid, reliable dividend payers
  • Corporate profits are historically high, but still have room to grow

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