Get your income here

BUY bonds for income and equities for growth. That is what many a financial adviser will tell you. But it isn’t really true any more. According to Citigroup, the dividend yield on the equity market is higher than the 10-year government bond yield in Australia, Canada, France, Germany, Japan and the UK. In the US, the two yields are neck-and-neck but equity investors can get an extra cashflow boost from buy-backs.

To some, this means that equities are ridiculously cheap. For much of the last 50 years, it was argued that equities should always yield less than government bonds because of the potential for the dividends to grow (whereas bond interest is fixed). Indeed, back in the 1990s, it was a general rule in the British market that gilts had to yield twice as much as shares.

But if one goes further back in history, the relationship was quite different. The figures, taken from the Barclays equity-gilt study, show the UK record back to 1900 (Britain tends to have the longest data set). In the first half of the 20th century, equities reliably yielded more than bonds; it was not until 1959 that they crossed over. Tellingly, this income differential was referred to as the “reverse yield gap” for a while.

The most plausible reason for the change was that institutional investors like pension funds and insurance companies were starting to dominate the market. In the first few decades of the 20th century, shares were mostly owned by individuals, who usually had a focused portfolio; they faced the specific risk that companies would go bust or cut their dividends. But a pension fund could diversify away that spoeific risk by owning a wide portoflio of shares.

It could be that institutional shifts have changed the relationship once more. Regulations mean that insurance companies need a steady capital base; they cannot afford to own that many equities. Pension funds are more mature in the sense they have more retirees and fewer workers, so they are less worried about growth; accounting rules also mean they favour government bonds.

But inflation must also play a role. Investors were caught out by the high inflation of the 1960s and 1970s that savaged their bond holdings; that encouraged the move into equities. Now inflation is very low again, bonds seem less of a risk.

So the big qustion for investors is; are we going back to the 1970s and 1980s? Or will markets look more like the first half of the 20th centuty? If the former, sell the bonds as fast as you can. If the latter, then this seemingly strange relationship will last. Equities may turn out be the best income provider.

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