Mind the (Yield) Gap
Taking higher investment risk requires the reward of higher return; otherwise, who would ever invest in the riskier activities? Just because the theory makes sense though, it doesn’t necessarily translate to your actually being rewarded – sometimes you just receive the risk. This article explains what ‘yield gap’ is. This will be of interest to those studying for their CII investments-related examinations.
Written by Mark Underdown
For a long period of time in investment markets, this extra return for the higher risk taken was mostly provided by the yield of the investment (i.e. dividend yield on stocks were higher than the yield of government bonds).
This is measured by something called the ‘yield gap’.
What is the yield gap?
The yield gap is the dividend yield of equities less the yield on long-term government bonds.
It’s a useful way to assess whether shares are overpriced relative to government bonds.
Until 1959, this was a positive number (i.e. shares yielded more than gilts).
Logically, this makes sense.
Shares are far riskier than gilts; therefore, an investor should be paid a higher amount of income each year to accept the increased fluctuation in value and risk of outright capital loss.
However, from 1959 to 2008, the yield gap reversed.
The Reverse Yield Gap
During this period, it became normal for shares to yield less than gilts.
This was justified, during this period, by earnings growth within businesses and, therefore, dividend growth, an inflationary environment (partly contributing to that nominal earnings growth) and simply share price escalation providing an additional element of investment return over and above the dividend yield.
It could also be due to the benefits of portfolio diversification being more widely used and reducing the risk of outright capital loss.
Whilst you will experience greater fluctuation in value, does a large portfolio of equities still have that much risk of outright capital loss? Historically, investors used to own a fewer number of shares; therefore, company-specific risk was a real issue. Nowadays, investors tend to own thousands of different companies and can effectively ignore company-specific risk.
These factors would justify dividends yielding less than government bonds.
Since 2008, the relationship has began to re-establish itself as a positive yield gap.
The gross redemption yield of the FTSE over 15-year gilt index is now only 2.15%, against a dividend yield of the FTSE All Share index of approximately 3.73%.
There could be many possible reasons for this:
- Monetary Policy – zero bound interest rates, QE and the myriad other financial interventions have surely distorted financial markets, specifically government bond markets.
When the FTSE Gilt (over 15 year) yield is only 2.15%, it would be rather unappealing if equities yielded less than this.
You do have to be paid at least something to compensate for the risk of capital loss!
- Investor mindset – With a few very large stock market plunges in recent times, your average investor is perhaps shying away from equities, with many perhaps still distrustful of shares and fearful of further crashes.
- Deflation – I’m not predicting it will happen, but people seem fearful of that threat and are perhaps more willing to simply accept a return OF their capital, rather than a return ON their capital. This view encourages people to favour ‘low risk’ bond investments over equities.
In this type of environment, there is likely to be lower earnings growth (and many would have earnings decline), restricting one of the key reasons for equities to yield lower than gilts in the past. It could well be that it’s the dividend yield that is too high – not necessarily the price of shares. By this, I mean that dividend’s would quite feasibly be cut in this type of environment. Low growth and yields are a rather unappealing prospect, seeming as so many need financial returns to have any chance of retiring comfortably, and they don’t have nearly enough capital to start eating into it to provide their income.
- Demographics – With an ever-increasing amount of people retiring, it’s inevitable that fund flows will move from equities towards gilts (either directly to lower risk profiles, or indirectly via annuity purchases and insurance companies). As the demographics of the population change, there may simply be fewer people willing, or able, to buy shares.
The Future Yield Gap
It will be interesting to find out whether the positive or negative relationship will be the norm for the next few decades. The impact for portfolio decisions and future investment returns could be significant.
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Over to You…
Did this post help you to understand what ‘yield gap’ is? Let us know in the comments!
Mark Underdown is The Nomad Paraplanner. He works remotely and can assist with investment research and financial planning reports. Visit www.nomadparaplanner.com to find out more.