Mind The Gap

In a recent newsletter, investment strategist Tom Stevenson of Fidelity makes a strong argument for equities to start to outperform corporate bonds.

His central case is that corporate bonds do well in periods like the one we’ve just been through, with companies raising cash and repairing their balance sheets. And with European corporate bonds now yielding only around 1% more than shares on average, the yield gap between bonds and shares is very narrow, Stevenson says, so equities are now better value. Furthermore, company bonds have become a crowded trade, he points out, with sterling corporate bonds the best-selling fund sector in every single month between November 2008 and August 2009, according to the Investment Management Association.

Stevenson’s point about the closing yield gap is particularly clear if one looks at continental European markets.

The iShares € Corporate Bond ETF has a gross redemption yield of 3.13% according to a fund factsheet published three days ago, available on the iShares website. The iShares DJ Euro Stoxx 50 ETF, which represents the largest 50 Eurozone blue chips, yields almost exactly the same (3.14%) according to the website. And if you take a dividend-weighted fund, the iShares DJ Euro Stoxx Select Dividend ETF, you get an extra percent in yield at 4.14%.

In the UK, things are less in favour of equities, partly because the iShares £ Corporate Bond ETF has such a major weighting (48%) in high-yielding financials, generating a current gross redemption yield of 6.01%. The iShares iBoxx £ Corporate Bond ex-Financials ETF yields a little less at 5.18%. On the equity side, the iShares FTSE 100 ETF yields 3.42%, the iShares FTSE 250 ETF yields 2.42% and it’s only when you go to a dividend-weighted fund, the iShares FTSE UK Dividend Plus ETF, that you get a yield close to that on corporate bonds – 5.21%.

In his newsletter, Stevenson goes onto say that the yield gap “is very low by historical standards and arguably does not really reflect the fact that a share’s dividend income will tend to rise over time while that of a bond is fixed. For this reason, bonds should yield more than equities and the average over the past 10 years, according to Morgan Stanley, is for corporate bonds to yield about two and a half percentage points more than equities. If today’s gap were to widen towards the long-run average then shares would outperform bonds.”

Is this a valid argument? Not necessarily.

Market historian and commentator Peter Temple points out that during the 1930s, equity yields were above yields on both corporate debt and government bonds – and this situation prevailed for another 20 years. “Before the cult of the equity developed in the late 1950s, equities traditionally yielded more than bonds because they were considered to be riskier, a view that today’s share investors could probably relate to. Before this, the yield gap was normally measured the other way round, how much more equities yielded than bonds.”

“From 1936 to 1958 equity yields fluctuated between 4% and 7% and bond yields between 2.5% and 3.5%. At no time in that 22-year period did equities yield less than bonds, and for most of the time they yielded substantially more,” Temple continues.

If this type of historical environment were to return, we’d be looking at a substantial further underperformance of bonds by equities from current levels.

Ultimately, whether we return to the bond-equity yield relationship of recent decades or that of an earlier period depends on how markets and economies extricate themselves from the post-credit bubble fallout: will inflation return, or are we stuck with a low-inflation or even flat or falling price trend? In the latter case, it would be difficult to generate much corporate earnings growth.

Whichever way things go, it’s as well being aware that the yield gap between debt obligations and shares has traded with both a negative and positive sign in recent history, and that current market levels do not give an unequivocal reading either way. Mind the gap, in other words.

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