Thursday 6 October 2011

Yield Convergence: US Dividend Shares & Treasury Bonds

The yield on dividend-paying US stocks is now at its highest level relative to US government bond interest rates in nearly 50 years. Yields from the two asset classes have now converged.

Is this a sign that the bear market is biting hard? Should this affect our DIY Income Investor strategy?

This observation on relative yields comes from an analysis reported in Horan Associates. Here's their graph of the difference between the yields of dividend yields and 10-year government bonds between 1953 and 2011 - currently hovering around zero.

Source: Horan Associates

This state of affairs is primarily due to the low level of  government bond interest rates, in turn due primarily - I suspect - to the continuing 'flight to safety'.

The article notes that (my emphasis): "given where bonds rates are today, it is hard to envision rates moving lower over the next three to five years given the state of the U.S. federal budget. Printing currency (higher potential inflation) and devaluing the dollar seems to be a likely path that will be pursued in Washington, D.C. Not if, but when rates turn higher, bond investors are likely to get hurt as bond values contract. For the dividend stock investor, corporate balance sheets are in pretty good shape with high levels of cash. A portion of these cash balances is likely to be used in increasing dividend payments to the company's equity holders."

In addition, the article provides a comparison of US asset class volatility, returns and correlations for the last decade. Dividend share prices have historically been more volatile (i.e. a higher standard deviation) than government bonds but the good news is that the two asset classes have been slightly negatively correlated.

Source: Horan Associates

So what does all this mean? For me, the main conclusions are:
  • 1) Although this is US data, there are likely to be similar features in the UK and other markets
  • 2) We are entering relatively uncharted territory for portfolio management, as the old 'rules' about asset mix are changing, although the lack of correlation between dividend shares and government bonds will hopefully continue (implying a volatility benefit of holding both asset classes)
  • 3) Interest rates on government stock influence returns on other fixed-income asset classes. so it may be a good time to try to lock in higher returns, such as those available from dividend shares
  • 4) Given the likelihood of continued inflation, it may be advisable to take any capital gains currently available on government bonds (gilts)
  • 5) Corporate bonds may also be attractive, given the positive cash position of many companies

Can you offer any other insights?

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

1 comment:

  1. I wonder if you've looked at the iShares LQD ETF - US / dollar investment grade corporate bonds - which has a high proportion of US banks and other US financials. The yield since inception is 6% (2002).

    My portfolio is skewed to the UK FTSE 100, Europe index etf and far east ex. Japan etf. I would be happy to have more exposure to the US equivalent of blue chips, but the US banks worry me a little. Richard.