Show me the money.

Many people understand the stock market-you buy stocks with the hopes that they go up over time. But some investors evaluate them differently. They incorporate both the movement in the stock (capital appreciation) and the level of dividends you receive on your holdings. Adding these two together gives you what’s called the ‘total return’.

Stock or Bond YieldFor example, is stock “A”’s price went up 8% last year and the company also paid out a 3% annual dividend, its total return would have been 11%. The same goes for bonds, but total return is referred to as the “yield to maturity.” For bonds, price movements are usually more subdued so the focus is more on the interest payments the company makes to bondholders.

This total return should be an important concept for investors. Investors approaching, or in retirement tend to focus more on the income the investment pays, because that fixed income payment is going to be part of their income once they stop working. Younger investors focus more on growth stocks for capital appreciation (and ignore dividend yields) portion since they tend to have longer-term time horizons (retirement is not imminent). But investors should realize that dividends are essential for portfolio growth. From 1929-2012, the total return of the S&P 500 Index was 9.4% (including reinvested dividends).1 Without dividends, the return from capital appreciation alone would have been just 5.2%, so almost half of the returns were attributable to dividends.2

Stock Yields vs Bond Yields

Investors looking for relative value view the stock and bond markets as competing with each other for investor capital. One way they compete is through this income yield (the amount of income an investor receives from the market, versus how much capital the investor must lay out) they offer.

For example, assume stock “A” pays shareholders a quarterly dividend of 0.27 cents per share. When you annualize the dividend you receive $1.08 (0.27 per quarter x 4 quarters in a year = $1.08). If you assume the stock trades at $36 per share, the stock ‘yields’ (or pays out) 3% ($1.08/$36= .03 or 3%). Now assume the stock market sells off sharply over the next quarter, causing stock “A” to fall to $27 per share. Assuming the dividend remains the same, if an investor buys the shares at $27, they will enjoy a 4% yield ($1.08/$27= .04 or 4%) if held for a year. As you can see, using yields can help investors discover value in the market.

There are times when the bond markets yields are higher than the stock markets, which may attract capital flows from income seeking investors. Conversely, there are times when the stock market may offer higher yields and capital will be drawn there. Here is a refresher on where dividend yields and bond yields stand for major benchmarks:3,4

  • Annual Yield on S&P 500 Index: 2.11%
  • Annual Yield on U.S. 10- Year Treasury Bonds: 1.53%

Some investors may perceive that the stock market offers better value (more attractive on a yield basis) than U.S. Treasuries. You’ll be getting roughly one half of a percent higher yield (58 basis points) buying stocks instead of bonds, all else equal (not considering any tax consequences or risk considerations).

Some Perspective

It’s important to understand these yields are near the low end of their historical ranges. For bonds, recall that in 2012 U.S. 10-Year bonds got down to 1.39% intraday.5 Conversely, bond yields went as high as 15.32% in 1981 when the U.S. was fighting inflation.6 For stocks, the yields ranged from a low of 1.11% in 2000 to a high of 13.84% at bottom of the Great Depression in 1932.7 If valuations normalize, stock market yields may drift back to their longer-term averages of about 4.4% for stocks and 4.60% for bonds.8,9 Looking at the valuations of financial markets by analyzing yield gives investors a broader perspective in terms of valuation.

Why are the Yields so Low?

Global central bank buying has skewed several financial markets. Zero interest rate policies and open market purchases have even caused the yield on some government bonds to go negative. There is now over $10 trillion in sovereign debt with negative yields, meaning investors would lose money if they held them until maturity.10 And it’s not just some obscure countries. Germany and Japan are among those with negative yields all the way out to their 10-year bonds. Switzerland’s 30-year bond yield even went negative today. The countries listed above are considered ‘safe haven’ countries and therefore continue to attract capital flows despite no yields. Some bond investors are turning to the U.S. Treasury bond markets and buying our bonds which have at least some positive yield. This has had the effect of keeping a cap on our rates. It is an unprecedented and rather bizarre scenario to be sure.

You may ask yourself why would investors invest in negative interest rates? One reason is that investors are attracted to the perceived ‘safety’ of sovereign or government bonds. They are willing to actually lose some money on the bonds for the safety of parking capital in them (Japan has its own special situation as it has been fighting deflation for a number of decades now). Another is that investors believe rates may push further into negative territory and believe the bond’s capital appreciation will outweigh the loss on the yield.

Other Benchmarks

With yields on bonds drifting lower for both stocks and bonds, we have seen investors flock into traditionally higher yielding sectors of the stock and bond markets. In the stock market, telecom, utilities and consumer staple have traditionally provided investors with above average dividend yields. Consequently, consumer staples and utility stock prices have been on a tear as investors reach for their above average dividend yields, often twice the overall market rate.

But sometimes investors can get a little bit greedy, as we saw in the energy sector earlier this year. When the price of oil collapsed, some popular MLPs (some of which were yielding double digits) were forced to cut the dividend after their operating income failed to generate enough earnings to pay out the dividend at prior levels. Here in lies a risk of investing in individual securities which can cut their dividends versus the entire stock market which is unlikely to do so.

The same goes for bonds. Low interest rates have renewed the appetite for high yield bonds (also known as ‘junk bonds’) which offer markedly higher interest rates, due to their higher risk of default. Junk bonds have ratings from credit agencies of ‘BB’ or lower (from Standard & Poor’s) and Ba’ or lower (from Moody’s, owned by Warren Buffett’s Berkshire Hathaway). The buying interest in them has brought their yield down from 10% early this year to just below 7 ½%. Many investors would gladly take on the added risk in the U.S. junk bond market (yielding 7 ½%) versus paying to buy the debt of some governments.

The long-term default rates on junk bonds are roughly 4.5%, but dropped down to 2.1% over the last couple years of the economic recovery.11 But there is risk in these bonds. High yield bonds in the energy space have been ravaged and some analysts predict that as many as half of all energy junk bonds will default. Oil has staged a big comeback so time will tell if that comes to fruition. But the junk bonds of many different commodity companies are in trouble. The Bloomberg Commodity index has gotten slammed since 2015, down about 50%. Metals, mining and some manufacturing company debt are worrisome to many market watchers. So, when using valuation ratios, include income yield for further perspective. And as always, speak with your financial advisor prior.

 

1,2http://www.advisorperspectives.com/commentaries/loomis_41812.php
3,7,8http://www.multpl.com/s-p-500-dividend-yield/
4,6,9http://www.multpl.com/10-year-treasury-rate
5http://www.forbes.com/sites/afontevecchia/2012/07/24/fear-over-everything-pushes-treasury-yields-to-record-low-below-1-4/#3633e9a11313
10http://www.wsj.com/articles/negative-yielding-debt-tops-10-trillion-1464915656
11http://www.investopedia.com/articles/02/052202.asp

 

Summary
Competing for Yield
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Competing for Yield
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Investors looking for relative value view the stock and bond markets as competing with each other for investor capital using income yield.
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FinancialCareerOptions.com
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