Bill Gross warned investors earlier this month to get ready for an ‘entirely different’ market, and likened the global bond market to a supernova with dire consequences.

Global bond yields are at the lowest in recorded history, with more than $10 trillion in bonds priced at negative rates, meaning investors are paying for the right to hold the bonds. Central bank policy doesn’t seem to be supporting economic growth, and many investors are wondering if more modest stock returns might be the norm going forward. 

#-ad_banner-#Banks and insurance companies can make do with returns low returns on U.S. government and corporate bonds. For most others, though, that’s not going to cut it. Plunging bond rates have pushed investors into traditional ‘safety’ stocks like utilities and consumer staples in a search for yield.

The stampede of investor money has driven prices in these sectors to alarming heights, and may make these safety stocks riskier than investors realize. If weak earnings start to unravel the perception of positive total returns the ensuing investor exodus could cause the whole group to unravel.

Two sectors offer a better yield opportunity with cheaper valuations, as well as historical evidence pointing to returns over the next year. They may be the only way to avoid the coming bond supernova.

Capitalism Doesn’t Work At Zero Percent
Global bond rates near or below zero have forced foreign investors into U.S. Treasuries, keeping U.S. rates lower despite relatively good economic growth. Besides warning investors of the potential for the bond bubble to explode spectacularly, Gross recently outlined his perspective on an entirely different market over the next decade or more. 

“10-year Treasuries in order to duplicate the 30-year history of bonds would have to drop to minus 15% [yield]. You can add 3% equity premium to all of that and come to the conclusion that if the 10-year is earning 1.8% then stocks would yield 4.8% to 5% and the market will be very different.”

Gross put the impetus on central banks to save business models and the market, saying finally that, “Capitalism doesn’t work at 0%.”

The lower rates on U.S. bonds have in turn forced investors into dividend paying stocks in a frantic search for any cash yield. The herding into non-cyclical sectors like utilities and consumer staples has driven prices through the roof and depressed yields.

But those supposed safe and non-cyclical sectors may not be as safe after being bid up to current prices.

More utility companies missed Q1 estimates for revenue than any other sector, with 86% coming in below estimates and 38% missing expectations for earnings. Of the ten sectors tracked by Factset Research the utilities sector is the third most expensive on a forward P/E basis, trading at 17.8 times estimated earnings and at a 23% premium to its 10-year average of 14.5 times forward earnings.

Consumer staples companies fared better than the utilities in Q1 with only 42% missing sales estimates and 8% missing earnings expectations, but the sector still only recorded 1.7% earnings growth over the last year. Consumer staples is the second most expensive sector on a price-to-earnings basis next to energy, which may be skewed due to plunging profits. The staples trades for 20.7 times expected earnings, a 24% premium to the 10-year average of 16.7 times forward earnings.

These traditionally ‘safe’ sectors may no longer be so safe, due to valuation and dependency on demand from yield investors. If the bond bubble starts to burst rates will start to rise and pull risk-averse investors out of these names and back into fixed income. Plunging stock prices and the vanishing perception of safety in utilities and consumer staples could then become a negative loop as more and more investors rush to the exits.

Where To Find Yield And Value In The Bond Bubble Supernova
There’s a safer way to find yield outside the traditional safety plays. Shares of real estate investment trusts (REITs) and MLPs have not participated in the great yield hunt to the extent as utilities and consumer staples. For REITs, the lingering memory of the real estate bubble has capped commercial RE lending and led to more modest growth. MLPs fell in unison with other energy stocks on the plunge in oil, even though the partnerships benefit from transactional pricing that partially shields them from lower energy prices.

Both investments offer a less expensive yield alternative and may be less volatile if the bond bubble starts to burst. Historical data on yield spreads for MLPs and REITs bear out the potential for strong returns over the next year, and the fundamental outlook is positive for both. Commercial U.S. real estate is performing well on the gradual economic recovery and MLP valuations have come down significantly on the drop in oil prices.

MLP valuations trade for an industry average of 7.6 times distributable cash flow, a discount of 36% on the 10-year average of 11.9 times DCF. The Alerian MLP Index yields 5.7% more than the 10-year treasury, a level only reached seven times in the last 235 months of data. Historically at the current yield spread, the index has returned an average of 26% over the following year. The rebound in the price of oil has allayed some of the debt concerns for MLPs and the Alerian MLP ETF (NYSE: AMLP) yields 9.29% on a trailing basis.

Estimates by Cohen & Steers put REIT valuations at a premium of 8.3% to net asset value and the four-year range between a 10% discount to a 20% premium. That makes the sector considerably cheaper compared to the 24.3 times valuation on trailing earnings for stocks in the S&P 500, trading at a premium of nearly 46% to their long-term average multiple of 16.7 times.

The Vanguard REIT ETF (NYSE: VNQ) yields 4.22%, for a spread of 2.62% over 10-year Treasuries and nearly 1% above the yield on the Utilities Select Sector SPDR (NYSE: XLU). Estimates for net operating income across the REIT sector are for 3.5% to 4.0%, well above inflation estimates and enough to allow for significant dividend growth.

Historical data on the yield spread on equity REITs and forward returns don’t show as strong of a relationship as seen in MLPs, but are still supportive of a positive total return. The current spread on the FTSE All Equity REIT Index to 10-year Treasuries is 1.96%, and is consistent with an average price return of between 3.7% and 10% on data back to 1995. This price return doesn’t include dividends, now at 3.8% for the index, so total return could be closer to between 7.5% and 13.8% over the next year.

Risks To Consider: REITs and MLPs may be volatile due to factors including real estate growth and oil prices.

Action To Take: Leave the bandwagon yield plays in utilities and consumer staples for safer cash and price returns in REITs and MLPs.

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