The Madness Of Tiny Gilt Yields

Published in Investing on 15 September 2011

There's a gaping gulf between share dividends and gilt yields.

Bonds and shares are completely unlike, yet some investors fail to understand the fundamental differences between them.

Shares are much riskier than bonds

Bonds are fixed-income securities issued by governments, companies and other organisations. In effect, they are company IOUs paying a fixed yearly interest rate (known as a coupon), plus they return your money in full when they mature.

Thus, bonds are 'shaped' a bit like a dumbbell: you put in a lump sum in at the beginning, collect a stream of interest payments, and then get your lump sum back at the end. As bond owners are creditors of a company, they are near the front of the queue when a company becomes insolvent.

On the other hand, shares are much riskier investments. Although shareholders own a company, this ownership doesn't give them too many rights. They can attend the company's annual general meeting and vote on resolutions, but not much else is guaranteed.

Though shareholders may receive dividends from the company (usually two or four times a year), these cash payouts are by no means certain. What's more, when companies get into financial difficulty, shareholders are right at the back of the queue.

Mind the gap

However, until the Fifties, there was a 'yield gap' between higher-yielding shares and lower-yielding Gilts (UK government bonds). In other words, the variable dividends paid by shares provided a greater yield than the fixed income paid by bonds. This was because share income at the time was seen as very uncertain and was, therefore, less highly prized.

However, celebrated investor George Ross Goobey thought this 'yield gap' bizarre, given the potentially greater returns on offer from investing in businesses, rather than bonds. Hence, he moved Imperial Tobacco's (LSE: IMT) pension fund's focus from Gilts to shares and made a fortune.

Thus, for the past 50 years, the market norm has been for shares to yield less than bonds, because of the scope for company dividends to grow over time. This is known as a 'negative' yield gap.

The yield gap goes positive

Right now, we have a positive yield gap, where shares yield considerably more than bonds. In fact, it's not so much a yield gap as a yield gulf or yield abyss.

Earlier this week, 10-year Gilts carried a coupon of 2.2% a year. That's right: in return for the safety of having your money backed by 'the full faith and credit of the British government', you get a measly fixed rate of 2.2% a year. While I'd be delighted to borrow at such a low fixed rate, I'd hate to earn it.

Currently, the FTSE 100 index of elite companies has a forward dividend yield of 3.8%. This means that the positive yield gap is 1.6% a year. However, over the past decade, FTSE 100 dividends have grown, on average, by about 3.3% a year.

In other words, investors would prefer to earn a fixed 2.2% a year than get an income starting at 3.8% a year with the potential to rise over time. Now I'll show you why this attitude is crazy.

2.2% fixed versus 3.8% growing

Let's put £1,000 into two 10-year investments: one paying a fixed yearly return of 2.2% and the other paying a variable 3.8%, rising by 3.3% a year. These are the income streams generated by the two investments (rounded down to the nearest pound):

YearBondShare
1£22£38
2£22£39
3£22£41
4£22£42
5£22£43
6£22£45
7£22£46
8£22£48
9£22£49
10£22£51
Total£220£442

As you can see, my hypothetical share pays out more than twice as much income over a decade than the bond does. For this reason alone, I'd buy the share every time.

Now for the bad news: as I said earlier, dividends aren't guaranteed and can be reduced or even cancelled. Of course, my dividends are unlikely to rise by a rock-steady 3.3% a year and could even fall.

However, they'd have to plunge by at least 13% every year before my total income came in below the £220 paid by the bond over 10 years. Even then, my share would still be better than the bond, because its income is higher in the earlier years (and cash in hand is king).

Three possible outcomes

Given this peculiar state of affairs, there are three possible outcomes:

1. Share prices are too low and investors should buy equities.

2. Bond prices are too high and investors should sell bonds.

3. A positive yield gap is the new norm and capitalism is set to revert back to the Fifties.

Personally, I think the third possibility is by far the least likely. Indeed, I believe that bond prices are blowing a huge bubble. At some point, this bubble will burst, causing hundreds of billions of dollars of losses for bondholders.

As for share prices, they look cheap on this and other fundamentals. Even so, with fear stalking the markets, they could yet fall further.

Then again, were the dividend yield for the FTSE 100 to fall to 4.4% (as seen during the depths of the 2008 crisis), this would be an unbelievable opportunity to buy. How often has the FTSE 100 dividend yield been twice the 10-year Gilt yield? Not often in my lifetime (43 years), I'd wager.

Shares with super yields

Right now, you can buy shares in global businesses paying dividends of more than double the 2.2% a year paid by 10-year Gilts. 

Here are eight selected 'super-yielders':

CompanyForward
yield (%)
Aviva (LSE: AV)8.6
BAE Systems (LSE: BA)6.4
Scottish & Southern Energy (LSE: SSE)5.9
AstraZeneca (LSE: AZN)5.8
Vodafone Group (LSE: VOD)5.5
J Sainsbury (LSE: SBRY)5.4
Royal Dutch Shell (LSE: RDSB)5.2
GlaxoSmithKline (LSE: GSK)5.1
AVERAGE YIELD6.0

These eight super-yielders should produce two to three times the income of a Gilt paying 2.2% over the next 10 years. If not, then I will give up investing and become a monk, because capitalism would be stone dead!

More on the markets

> Cliff owns shares in GSK. The Motley Fool owns shares in BAE Systems, Scottish & Southern, GSK and AstraZeneca.

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Comments

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alarmbells 15 Sep 2011 , 6:33pm

Current interest rates are at "artificial" and "engineered" mega low levels. More "normal" gilt yields should be nearer 4%, I reckon without all the state intervention and QE. On that level I'd agree equity looks tasty at 4.5% yield, but I only think equity fair value at 3.8% yield.

The really weird one is today's launch of the NG index linked bond. The £100 purchase price wil be increased by RPI each year, and the coupon (yield) of 1.25% will be increased by RPI each year. Ove the next ten years.

Now why would you buy this bond rather than the shares? Say you get a couple of years maintained dividends. Then say calamity! The dividend is eliminated! Then, say the company resumes dividends at 3% pa. It is almost impossible to create a sensible environment were the bonds are at all attractive.

The point is if you NEED the capital at some point in the future. As we all know, share prices go up and down like a tinker's elbow. But in ten years time the NG bond will be worth £100 in real terms.

F958B 15 Sep 2011 , 6:34pm

Prior to the 1970's, currency was (supposedly) backed by gold, which meant that inflation (theoretically) should be close to zero - even slightly negative due to "productivity" gains allowing us (or machines) to produce the same stuff faster and cheaper as time passes.

Unfortunately, governments couldn't offer a lavish welfare state and live within their means as required to stick to a gold-backed currency, so they began to inflate/devalue/borrow to make up the shortfall which they didn't dare tax from the population.

I believe that it was the lack of monetary discipline post-WW2 which caused investors to wake up to the effects of inflation on bonds, whereas equities could largely pass-on inflation effects in terms of pricing, and subsequently we saw the yield on bonds adjust to the point where inflation-vulnerable bonds paid more than shares.
Roughly speaking, it should be that:
dividend yield + inflation - small risk premium = bond yield.

I'd estimate that "typical" values in the above equation would normally be:
4% dividend yield + 4% inflation - 1% risk premium = 7% bond yield.

At the moment, we have:
4% dividend yield + 4% inflation - 6% risk premium = 2% bond yield.

Conclusion:
Bonds are a bubble.

DIYIncome 15 Sep 2011 , 10:18pm
newlyretired 16 Sep 2011 , 10:34am

Hi Cliff

It was actually Alastair Ross Goobey's father, George Ross Goobey, who, as manager of the the Imperial Tobacco pension fund, first moved from investment in gilts to investment in equities:

http://www.cityoflondon.gov.uk/Corporation/LGNL_Services/Leisure_and_culture/Records_and_archives/Events/George+Ross+Goobey+Papers.htm

timeandpatience 16 Sep 2011 , 1:36pm

Yes - I think newlyretired is right - from memory (although I may be wrong) George Goobey's move into equities is touched on in some detail in John Littlewood's excellent book "The Stock Market (Fifty Years of Capitalism at Work)".

(The book is also an excellent source of historical information about the long term movements of the stock market and helps to place today's gyrations into a wider context - the chapter on the early 1970s is particularly informative).

CunningCliff 16 Sep 2011 , 2:38pm

Hi newlyretired,

Oops, you're absolutely right. Silly me, I'll get this changed right away.

Thanks!

Cliff

backdated 16 Sep 2011 , 4:51pm

Hi Cliff.

"Bonds and shares are completely unlike, yet some investors fail to understand the fundamental differences between them."

Then why use a comparison of "yields" to suggest one is better than the other?

I wonder how cash kick-outs (dee-vee-dends) will fair if depression and deflation do take hold over the years ahead.

F958B 16 Sep 2011 , 9:31pm

backdated

The Fed themselves said that deflation will not be allowed in the US:
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Deflation is easy to stop: just devalue the currency (a.k.a quantitative easing).
If inflation becomes severe; mail-out wads of £100 notes to the general public; banknotes don't cost much to create.

Even Japan's post-super-bubble experience was more "disinflation" than deflation.
Japan's disinflation was because:
1. Post-super-bubble
2. Strong currency.
3. Slow and inadequate government response to the monetary problem.
4. Worries over inflating away the value of their aged population's cash savings.


I think that the future will not see a deep depression, nor a deep deflation, nor hyperinflation.
I think that we'll see a prolonged period of sub-par, erratic growth, with negligible wage rises, moderately elevated unemployment, sluggish, erratic or mildly declining property prices, interest rates stuck at a low level and inflation stuck at a slightly elevated level.
Official inflation would most likely be under-stated (as it has been for many years), to reduce the burden on welfare/pension payments.

We'll get slowly poorer over a prolonged period. People's spending will gradually need to have ever-greater amounts directed to life's essentials as prices rise but incomes remain subdued.

With many UK companies having significant overseas activities, the FTSE performance could depend on what's going on elsewhere in the world.

My portfolio is positioned quite defensively; in high-ish-yield consumer non-discretionary (food, pharmaceutical, utility, tobacco, telecom - I'd have alcohol too, if the prices were right).
Many of those companies also operate overseas, in nations which aren't as burdened by our problems.

.

goodlifer 28 Sep 2011 , 10:55pm


Thank you Cliff for a very interesting, important and informative article - I've saved it, in the hopes that I can digest it properly.

Most importantly bonds, it seems to me, give you no protection against inflation.
Equities do at least give you some

With zero inflation many of us wouldn't bother to be in the market at all.

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