Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi Asset Solutions Team.
Throughout most of last year, the 10-year Treasury yield was well below the S&P 500 Index’s dividend yield, enticing income-seeking investors to find solace in equities over Treasuries. Fast forward to today: The 10-year Treasury yield has been moving in fits-and-starts, but has surpassed the dividend yield on the S&P 500. Some people have expressed concern about this: Now that the relationship has reversed, will income-seeking investors flock back to Treasuries?
I believe they probably won’t. Here’s why, along with some insights for investors who may be seeking income, but are wondering where and how to look.
What should investors be contrasting, yield or total returns?
For most of the period from 1960 through August 2017, Treasury yields have exceeded the dividend yield on the S&P 500. But the contrast between yields is only part of the story. Let’s instead compare total returns, a more comprehensive measurement that takes into account security price changes, and factors in income from stock dividends and bond interest. In 57.9% of the months from January 1960 through August 2017, the S&P 500’s return was greater than the return on the 10-year Treasury index.
Comparing the total returns of the 10-year Treasury and S&P 500
(January 1960 through August 2017)
|10-year Treasury||S&P 500|
|Inflation-adjusted real total returns||406%||2,706%|
Is there a reason to worry about equities versus bonds in a portfolio? Perhaps, but if investors are worried about the dynamic between the two asset classes, a more constructive way to address their concerns can start with revisiting their asset allocation mix, in the context of their goals, time-horizon, and risk tolerance.
Does it matter if Treasury yields surpass the S&P 500 dividend yield?
There’s little, if any, persistent and predictable relationship between Treasury yields and any equity valuation metric, like dividend yield. In theory, rising Treasury yields would push stock prices down, as discount rates of future dividends rise—but dividends aren’t as reliable and predictable as Treasury coupon payments. Investors shouldn’t treat Treasury payments as being as risky as dividend payments. As Treasury yields rise, equity risk premiums can potentially rise or fall.
It all depends on why Treasury yields are rising. If it’s because growth is looking good, maybe investors will expect higher dividend payments in the future, or they’ll get more confident that those payments will be made, pushing the equity risk premium lower. However, if it’s because inflation is picking up quickly, then investors might think the Federal Reserve will snuff-out growth with a faster pace of rate hikes.
Most investors expect capital gains from equities in addition to dividends, so dividend yield is not the only appeal of equities. Companies can create value for shareholders by reinvesting in the business or they can distribute value to shareholders through share buybacks or paying dividends. As a result, the dividend yield is likely a poor guide to identifying value in equities, let alone comparing dividend yields to Treasury yields for identifying relative value.
Instead of comparing yields, why not focus on the diversity within them?
With regard to those who worry about Treasury yields moving above dividend yields—perhaps they’re concerned because income-seeking investors have been flooding into equities at times when income was scarce in the Treasury market.
But don’t forget that there are many steps along the risk spectrum between Treasuries and equities. There’s investment grade corporate bonds, high yield corporate bonds, structured products, and a variety of other waystations for investors to rest, before making the jump from Treasuries to equities. In economics, we’d say that Treasuries and equities are hardly perfect or even close substitutes.
Dividend yields across equities are quite diverse. The S&P 500 has a dividend yield of 2.1% (as of 9-8-2017), but the S&P 500 Information Technology Index has a dividend yield of 1.41%. Meanwhile, the S&P 500 Telecommunications Services Index has a dividend yield of 5.34%.
There’s a wide variety of yields available in U.S. equities and an even wider variety outside the U.S. The MSCI Emerging Markets Index has a dividend yield of 2.33%, and the MSCI Europe Index has a dividend yield of 3.35%. Instead of fearing that higher Treasury yields will lure equity investors out of U.S. equities, maybe those who are looking for income will just migrate to higher yielding parts of the equity markets.
Final thoughts for investors
The global markets offer so much more than a binary “Either you’re in Treasuries or you’re in the S&P 500” environment for investors. That’s probably why worrying about whether dividend yields are higher or lower than Treasury yields has never yielded much insight for investors as to where the opportunities are. Instead, those who are looking for income may want explore a multi-asset and global approach to building a portfolio.
In that regard, investing for income entails two forms of decision-making, asset allocation and asset location.
The asset allocation decision involves choosing assets that can create a targeted amount of income with an acceptable amount of variation in income. Treasury bonds tend to be very predictable while dividends are paid at the discretion of stock-issuing companies’ boards of directors. Some companies have better reputations than others for paying dividends. Some countries have historically had higher dividend payouts than others, like Europe versus Japan.
The asset location decision is also important, as different types of income can be taxed differently. This includes income from municipal bonds, Treasury bonds, corporate bonds, foreign bonds, master limited partnerships (MLPs), and real estate investment trusts (REITS). For stocks, dividend income can also be treated very differently and may belong in different types of accounts (tax-deferred versus taxable, for example) depending on the character of the income. Changes in tax rules and changes in corporate culture can also affect the propensity of firms to pay dividends and how much.