The price of popularity
I write about stocks much more often than bonds. It’s not that I don’t like the latter, quite the contrary. Back when I worked as a mutual fund analyst (exchange-traded funds hadn’t yet been invented), I preferred to research fixed-income funds rather than their equity rivals. Stock fund managers told stories, but quality bond funds mathematics. They were tangible.
Unfortunately, the calculations in recent years have rarely worked in their favor. To quote Jimmy McMillan, their rent is way too high. Due to several factors, including discomfort with stocks after the 2008 global financial crisis and America’s aging, bonds have become more popular than stocks. As a result, their yields have fallen, making them significantly less attractive than stocks.
Consideration 1: Bond Yields Versus Stock Dividend Yields
How do bond and stock prices compare? In the past, investors believed that the dividend yield of stocks should exceed that of government bonds. After all, stocks were riskier. From 1900 to 1960, this principle almost always applied. For the most part, 10-year Treasuries yielded 4%, while stock dividends yielded 6%. This latter figure has fluctuated significantly due to changes in both the numerator (dividends declared) and the denominator (stock prices). But they were significantly higher than Treasury yields.
Historically, this relationship made sense because the stock market was a mess. Despite the country’s impressive growth rate, U.S. stock market returns barely exceeded those of bonds from George Washington’s presidency until World War II, thanks to a combination of poor corporate governance and inconsistent government policies. When companies were as likely to defraud their shareholders as to compensate them, or to disappear abruptly through bankruptcies, they had to offer large ongoing payouts to justify their risks.
Markets are evolving
Once the U.S. stock market came of age, this measure was far too conservative. On average, companies paid out only half of their profits as dividends, reinvesting the other half in their operations. Thus, shareholders received: 1) high current returns from 2) well-regulated companies that operated in 3) a stable and healthy economy. These companies were also 4) growing rapidly because 5) they had reinvested a large portion of their profits into their operations, allowing them 6) to continually increase their dividends and/or repurchase their stock.
Good job if you can get it! But for a long time, you couldn’t do it. From January 1962 to December 2008, 10-year Treasury yields consistently exceeded stock dividend yields. The global financial crisis ended this streak, as the implosion of the nation’s banking system prompted many investors to swap their stocks for bonds. This made sense, because the 2008 calamity was real and deeply threatening. What doesn’t make sense is that for most of the 15 years since then, stock dividend yields have remained close to those of the Treasury.
Consideration 2: Bond Yields Versus Stock Yields
My point in pictures: bonds have been unattractive! But recently their relationship with stocks has changed again. Treasury yields have soared, while dividend yields have remained stable. It is certain that this change is not enough to make bonds attractive. Paying more income than stock dividends is a starting point for evaluating bonds, not an end point. A fairer test is to compare Treasury yields with those of the stock market. profit yield– that is, the overall profits of American companies divided by the total value of their shares.
As a guide, these amounts should be similar. Treasury bonds have the advantage of guaranteed returns: no one will take them away. (Whether these distributions are seriously eroded over time by inflation is another matter.) However, fixed payments are a double-edged sword. Barring an exceptionally bad economy, companies will inexorably increase their annual profits, while Treasury yields remain constant. What started as a balanced trade will tilt in favor of stocks.
Overall this constitutes a fair trade. If bond yields match the earnings yield generated by stocks, then bonds offer an equivalent underlying rate with significantly greater security, at the expense of growth potential. Win some, lose some. Indeed, this is how investors have generally valued both asset classes throughout the modern era, until the post-2008 anomaly.
Consideration 3: Absolute returns
This second chart suggests that after being overvalued for 15 years, bonds are now reasonably valued. Not enough. It is true that the relative the yield on 10-year Treasuries (and therefore other medium- and long-term investment grade bonds, as the yield curve is nearly flat) has returned to its historical norm. Overall, modern investors share my view that Treasury yields should resemble the stock market’s earnings yield. And that’s currently how bonds are valued.
Unfortunately, absolute the yield is also important – and it is unfortunately low. In September 1980, the 10-year Treasury yield also slightly exceeded the stock earnings yield, as it does today. But the two circumstances are very different since in the fall of 1980, Treasury bonds paid 11.57%! This amount provided powerful protection against inflation. If annual inflation averaged 6%, Treasury investors would still make a nice real profit. Even a rate of 9% would be acceptable.
This is not the case today. For Treasury bond holders to earn a significant after-inflation return, consumer prices must be nearly stagnant. The same precept does not apply to stocks, as their profits increase. In summary: while in 1980 both asset classes could tolerate moderately high future inflation, today only stocks benefit from this possibility. With yields of 4%, bonds don’t stand a chance.
Conclusion
Inevitably, this article contains a built-in macroeconomic hypothesis. This assumes that corporate profits will continue to rise, rather than languish as predicted by bond fund manager Bill Gross’ famous (and inaccurate) 2009 paper, “On the ‘Road’ to a New Normal.” If corporate profitability stagnated, bonds would become more attractive. I doubt they will outperform stocks over time, but the return gap could be surprisingly narrow.
However, under the most likely economic conditions, my long-held view persists: stocks remain the best investment bet. I would write this even if Treasury yields hit 5% – but I admit that 6% would be tempting.
The opinions expressed here are those of the author. Morningstar values diversity of thought and publishes a wide range of viewpoints.