Relationship between bond and dividend yields has no grounds

Investors can make great returns in stocks over many years even as rates rise.

  • By Stuart Kirk,
  • Financial Times
  • Investing in Bonds
  • Investing in Stocks
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Finance is a place where myths go to live. And they survive by eating away at investor returns.

One of the most enduring is that higher interest rates are bad for share prices — itself a relative of the myth linking bond yields to earnings or dividend yields. Both are so established that a valuation methodology is based on them — the so-called "Fed model".

Stocks vs. bonds for the next decade

Valuations and rising rates could make bonds more attractive.

That many investors believe in the Fed model is perplexing, as any relationship between bond and dividend yields has no ground in fact or theory. None whatsoever.

Yet the myth is stronger than ever. Equity markets are struggling this year in part because bond yields are up, or so the story goes. Indeed, some readers of this column will have reduced their equity exposure recently as they worry that the era of low interest rates is over.

There is a reasonable chance, however, that such a move could be expensive in terms of performance lost. To understand why, investors need to understand where the bond versus dividend yield myth comes from and how it perseveres.

Luckily, the answers are simple enough — they are the usual mix of extrapolation from recent experience, egregious data-mining and muddled theory.

Start with the facts. A robust analysis of investment returns always means looking back as far as possible. Not since the financial crisis. Not since the millennium or a couple of decades, either — this is noise.

The US has reliable data on S&P 500 dividends and 10-year Treasury yields from about 1950, but the numbers tell the same story the world over. Be wary of anyone suggesting a relationship over shorter periods — they are being deliberately selective in order to sell you something.

What first leaps off a chart as you scan your eyes backwards over 70 years is the roaring 1980s and '90s, when both bond and dividend yields moved lower and lower in tandem.

Those decades coincided with an explosion in share ownership and hence the narrative of falling interest rates boosting equity prices became lore. So much money was made it is no wonder that investors fear the reverse happening now.

But the second thing you notice is even more striking. A long run view also makes it clear how abnormal this period of concurrent falling yields actually was.

By contrast, during the 1950s and '60s bond yields rose as dividend yields fell. In the 1970s, however, both moved higher together. And a different relationship again post 2000 — this time declining bond yields coexisted with rising dividend yields. Four unique periods with four unique results.

In other words no historical relationship between bond yields and dividend yields. By extension this means that interest rates have nothing to do with share prices as the former lead bond yields while dividend yields move with earnings yields (the latter being the inverse of the price/earnings ratio). Yes correlations can be found in the short run, but they are statistically meaningless.

And if the myth has no basis in fact, it has even less in theory. This is hardly surprising when you stop and think about it for a minute.

Dividends are paid out of future company profits and are a claim on real assets. Therefore, the worth of these dividends holds its own with inflation. Bond coupons on the other hand are paid out in nominal terms and do not adjust to inflation.

We have a classic pears and apples problem. This is further amplified by dividend yields being relatively stable because earnings yields mean revert with margins.

Bond yields are more volatile because of long, random swings in inflation rates. Of course, general prices can be stable for years, giving the illusion of a relationship. But it is based on luck and no one knows in advance the direction.

Another theoretical misconception is that rising bond yields mean that future dividends should be discounted at a higher interest rate, thus reducing their net present value.

This is so widely believed today it is hard to imagine that in the 1950s and 1960s, when share prices were rising with higher bond yields, everyone was just as convinced of the opposite theory that inflation lifts the future value of dividends.

Both arguments are nonsense for the following reason. During periods of rising inflation and bond yields, forward nominal earnings move higher but so should future interest rates — with the two cancelling each other out.

Likewise, deflation crimps the value of future dividends but concomitant lower interest rates compensate. (This is why analysts must use a normalised discount rate in their models).

There are many legitimate ways to value equity markets. Comparing bond and equity yields is not one of them. Do not let a myth ruin your portfolio. It is perfectly possible for investors to make great returns in stocks over many years even as bond yields rise.

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