Low Gilt Yields Say That Shares Are Cheap

Published in Investing on 2 July 2012

History dictates that when shares have yielded much more than bonds, it's time to buy shares.

In 1956 George Ross-Goobey, the manager of the Imperial Tobacco (LSE: IMT) pension fund, persuaded the scheme's trustees to switch most of its holding of British government fixed-interest gilts that were paying 3% into shares that yielded 4%.

This meant that not only did the fund obtain a higher income, but it also got some protection against inflation. The difference between the income paid by gilts and shares -- the "yield gap" -- had been justified on the grounds that shares were riskier investments; by the early 1960s gilts yielded more than shares, a situation which became known as the "reverse-yield gap".

The yield gap has reappeared during the last few years, thanks to the recession and investors' fears that things will become a lot worse. So while the gross redemption yield on 15-year gilts is just under 2.4%, an index-tracker fund like the HSBC FTSE 100 (LSE: HUKX) currently pays 3.6%. That's 50% more than on 15-year gilts and it comes net of basic rate tax, but it isn't guaranteed.

Why are gilt yields low?

The yield on long-dated gilts has fallen because of several factors, one of the most influential of which has been the Bank of England's response to the recession and the credit crunch. By slashing interest rates, the Bank increased the attractiveness of gilts, while most of the money that it has pumped into the banking system through quantitative easing has gone into gilts, which has further depressed yields.

Many investors reacted to the world's economic problems by switching their money out of riskier assets and moving into gilts. The flight of money from less financially stable countries into the government bonds of the more stable economies such as America, Britain, Canada and Germany has further driven down gilt yields.

In Britain, the demand for gilts has also risen because final salary pension funds are forced to increase their level of investment in fixed-interest bonds when gilt yields fall. Most other European countries have similar laws, which to the cynical-minded like me have always looked a lot like a way for the state to force domestic institutions to buy its debt.

We'll pay you to look after our money

The economic problems of some eurozone countries are so bad that many investors who need to hold euro-denominated debt have turned to the most secure form: the short-term bonds that are issued by the German federal government.

The demand for German debt has been so strong that a recent issue of two-year "bunds" which paid no interest was snapped up and negative interest rates, where investors are guaranteed to get back less than they put in, have been recently seen in the German bond market.

Investors buy these zero interest bonds because, to them, the return of their capital is much more important than the return paid upon their capital. They don't want to risk the chance that they'll wake up one day to find out that the government whose bonds they hold has partially defaulted upon them and/or has exited the euro so their bonds have been redenominated in a less valuable replacement currency.

Bond issuers love inflation

Milton Friedman showed us that inflation is primarily a monetary phenomenon that is caused by governments printing money. Inflation is an insidious tax upon the value of assets, especially cash and fixed-interest investments, though it is popular among debtors because it reduces the real value of their debts.

So with Britain's national debt now approaching 80% of the gross domestic product, and a lot more once the off-balance sheet stuff is included, it will be very tempting for future governments to let inflation rip. Though since inflation has reduced the purchasing power of £1 in 1960 to about 6p today, this seems to have been official policy for most of the last 50-odd years!

Investors who kept their money in real assets such as gold, property, shares and inflation-linked bonds, which can keep pace with inflation, have done much better over the last 50 years than those who kept their money in cash and/or fixed-interest bonds.

One consequence is that nowadays many countries' bonds, rather than offering a risk-free return to investors, appear to give what James Grant, the publisher of Grant's Interest Rate Observer, calls "return-free risk".

Think long term

Since the 1950s, history tells us that whenever shares have yielded much more than bonds this is a strong signal to buy shares if you are prepared to take a long-term view and can ride out any further price falls as the yield gap invariably appears during an economic crisis.

History also tells us that buying bonds at very low yields is a good way to lose money over the long-term. You can see this in the most recent Barclays Capital Equity-Gilt study, which shows that investors who bought American Treasury bonds that paid 2% just after the end of the Second World War earned a real annual return over the next 35 years of minus 2.3%.

Plenty of good dividends

Lots of companies in the FTSE 100 (UKX) pay more than the 3.6% yield paid by a typical index tracker. Two of the more popular among investors are the oil supermajors, BP (LSE: BP) and Royal Dutch Shell (LSE RDSB), whose shares pay dividends of 4.6% and 4.9% respectively.

Some companies pay higher dividends, in particular the utilities like National Grid (LSE: NG), whose shares yield 5.5%. Many investors view utility company shares as being a hybrid of index-linked bonds and conventional shares, as their regulated monopoly allows them to impose price rises upon customers who have no alternative but to pay up. So their cashflows should be much more predictable and their dividends should grow steadily over time.

But the utilities' dividends aren't guaranteed, unlike the returns paid by gilts, and they are exposed to the sometimes capricious behaviour of their regulators and populist utility-bashing politicians. The example of the privatised phone companies around the world, whose monopolies have been eroded by the rise of the mobile phone, is something to also bear in mind.

Two utilities with local monopolies and businesses that are exceptionally resistant to technological change are the electric company SSE (LSE: SSE) with its 5.8% dividend, and the water company United Utilities (LSE: UU), which yields 4.7%.

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> Tony owns shares in National Grid, but none of the other companies mentioned.

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Comments

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alarmbells 02 Jul 2012 , 4:02pm

BOE QE has artificially decreased yields on Gilts. Had this not happened Gilts would have been yielding what they were 5 years ago plus or minus 10% or so.. In other words the current "normal" 10 year gilt yield would be somewhere between 3.6% and 4.4%. Equities are therefore not cheap but probably fair value.

If FTSE 100 was yielding 4.4% it would be approaching bargain territory, so i'd wait for a drop to 5000 before filling your boots.

TomRoundhouse 02 Jul 2012 , 9:40pm

I agree with alarmbells. The gilt market is rigged and whether we like or not gilt yields are probably at their long term nadir. When yields start to rise and rise they will, this will be accompanied by a donward re rating of equities. As gilt yields rise equities will have to provide an increasing yield to justify their valuation and unless earning explode the only way the realtionship between gilts and equities will be re established is via lower valuations. Equities are certainly not cheap enough.

kiffberet 03 Jul 2012 , 2:59am

I too agree with Alarmbells and when the FTSE is actually cheap, then I'm going to call it cheap. At 5600, with the country in recession, with Europe in recession and a slow down in Chinese and US growth, the FTSE looks pretty far from cheap.

ANuvver 04 Jul 2012 , 6:44pm

TomRoundhouse:

"When yields start to rise and rise they will, this will be accompanied by a donward re rating of equities."

A fine point as far as it goes. But are you not rather thinking primarily in terms of fresh money coming into markets?

Another interpretation would be that a lot of the money currently in sovereigns is there from the motivation of capital gain rather than yield. As and when bill yields rise, cap gains from these positions will fall off and investors will start to take profits and look for a better home for the proceeds.

In a low-interest-rate world, that could very well lead to a renewed interest in risk-on assets and a significant swing towards old-fashioned yield-based thinking. Or to put it another way, as bond yields rise, more and more risk will be seen as attaching to that asset class. I don't think it would take much momentum in that trade for the zetgeist to start shifting to: "I have to accept risk everywhere so I might as well look for yield".

Of course, this is a multi-faceted issue. A lot of institutional funds are being coerced into sovereigns for reasons we're all aware of, and quite a lot of private funds are following the trend out of fear. Both are quite happy - for now - since that confluence of circumstances and attitudes has been producing decent capital gains.

Bear in mind also that given economic slowdown in the West, there is likely to be far less fresh money coming in (well, unless you tell crass jokes or write turgid piano ballads for a living...) Personally, I'm more concerned with the existing amount of water currently in the system and how it may slosh from one side to the other.

Just another perspective, of course.

browny33 07 Feb 2014 , 12:33pm

As with any market, when the mainstream media is shouting "buy, buy, buy..." it's time to sell. When it is saying the market still has a long way to fall it's time to buy...

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