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Paying dividends

Tom Stevenson

Tom Stevenson - Investment Director

The FT published an interesting chart this morning. It showed the yields being offered to investors by two types of US government bonds and by US shares over the past thirty or so years.

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In both cases the yields have fallen since the 1980s. No surprise there. You would have to be pretty inattentive not to have noticed that the cash returns on investments have declined over that period.

But what is striking is how the downward slopes differ. In the case of shares, the yield has fallen from about 4% to just under 2%. Indeed since 2000, when shares were notably expensive and yields consequently low, the dividend yield from equities has actually risen a bit.

When it comes to bonds, however, the fall has been dramatic - from about 9% to pretty much the same yield of just under 2% for both 3-month and 30-year Treasuries.

For almost all of the past 30 years, therefore, you have been able to secure a higher income from bonds than from shares, but not anymore.

The historical relationship makes logical sense. Bonds have traditionally paid a higher income than shares because the pay-out from fixed-income investments is, as the name suggests, constant. Shares, on the other hand, offer the prospect of a rising income over time.

That means that you should be prepared to accept a lower starting income from a share in anticipation of its future growth.

The only exceptions to this general rule have been moments of extreme stress in the stock market. In 2008/9 for example, at the height of the financial crisis, shares fell so sharply that they yielded more than 30-year bonds for a brief period. They yielded a lot more than the 3-month flavour because the income from these short-term bonds is largely determined by interest rates, which as we know the Federal Reserve slashed to pretty much zero at that time.

The only other periods in recent years when the yield on shares has been close to that on 30-year bonds were during the Eurozone sovereign debt crisis in 2012 and the China-fuelled growth scare in 2015.

Until now that is. This week, the yield on the 30-year Treasury fell to 1.94% while that on the S&P 500 index of leading US stocks stood at 1.98%. What is this telling us?

There are two possible readings of this new relationship. The first is that shares are cheap, as they were in 2008. Given that money has to be invested somewhere if it is not to be stashed under the mattress, the fact that you can get a bigger return on shares than bonds ought by rights to push cash towards the stock market.

This chase for yield is a powerful force, as we are seeing at the moment as investors pour money into the Italian bond market despite that country’s political turmoil. Italian bonds are attractive simply because they offer so much more than other safer, but negative-yielding bonds in Germany, for example.

The problem with this first relative yield argument, however, is that it ignores the message that dwindling bond yields are sending investors about the outlook for economic growth and company profits. The second possible reading says that yields are so low because investors are concerned about a downturn, possibly even a recession. Low long-term bond yields, especially when they fall below shorter-term ones, have been a good indicator of trouble ahead in the past.

If there is a serious slowdown then the ability of companies to maintain their dividends, let alone increase them, will naturally be compromised. And going back to the earlier logic about no-growth income needing to pay a higher starting yield, that makes the case that the dividend yield on shares really should be at least as high as that on bonds. With a payment from the US government, you can at least be fairly certain that it will be honoured - companies make no such promise.

So, the fact that shares are yielding more than bonds does not guarantee outperformance by shares. Far from it.

What it does suggest, however, is the need for balance. Neither bonds nor shares are obviously better value than the other asset class at the moment. And without a crystal ball, the clear conclusion from that analysis is that holding a bit of both makes sense.

The Fidelity Select 50 Balanced Fund is designed to give investors a smoother ride by investing across both bonds and shares, and all around the world too. For investors struggling to make sense of the changing face of comparative yields, it might be a sensible place to wait for more clarity.

Read more about Fidelity Select 50 Balanced Fund.

Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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