What Dividends Can Do That Bonds Can'tOctober 2002As most investors and all borrowers know, current interest rates are at their lowest levels in a generation. As the chart below clearly shows, interest rates peaked in the early eighties and have been trending downward ever since. The economic weakness that came on the heels of the late nineties technology boom, and subsequent bust, led to eleven consecutive cuts by the Federal Reserve in 2001. The Federal Funds rate (red line) currently stands at just 1.75%. Similarly, US Treasury rates are at multi-year lows; the 10-year Treasury (yellow line) now stands at 3.6%, the lowest level since the early 1960’s. As we will see, this low level of rates has implications for returns going forward.
While we consider the level of interest rates on government bonds, we must also focus on the difference between Treasury yields and the yield on corporate bonds. Corporate bonds have not benefited, to the extent of Treasury bonds, from the recent drop in interest rates. As the nearby chart illustrates, credit spreads, the difference between the yield on a corporate bond and that of government bond with the same maturity, have widened in recent years. The fact that the spreads have widened reflects the perceived increase in risk of investing in corporate bonds, which are backed by the issuing corporation, versus government bonds, which carry the full faith and credit of the US government. Revelations of financial mismanagement at companies such as WorldCom and Enron have increased the level of perceived risk associated with corporate debt. For an investor to take on this higher level of risk they demand a higher return, which is represented by higher yields on corporate issues, or, in other words, higher credit spreads. It is instructive to look at the last time the perception of corporate risk increased and credit spreads were this wide, the early nineties. As the economic picture improved and the bull market reappeared after the brief ’90-‘91 recession, credit spreads did not immediately fall to their pre-recession levels. We do not expect this time to be any different. Credit spreads should remain large for a while but careful credit analysis should provide select opportunities for corporate bond investors.
With rates at multi-year lows, it is worthwhile to compare the return one might receive by investing in Treasuries versus an alternative investment. If we examine the historical relationship between the S&P 500 index and the yield on the 10-year Treasury they have shown strong negative correlation, i.e. when interest rates have fallen, stock prices have generally risen. However, as the chart alongside illustrates, more recently the two have shown positive correlation, i.e. falling rates have been accompanied by falling stock prices. In a historical context, a 10-year Treasury at current levels would imply a much higher level of stock prices. It is also interesting to note that when comparing the 10-year Treasury yield with the projected price/earnings (P/E) ratio of the S&P 500, a similar, positive correlation can be observed. Higher interest rates have historically been strongly correlated to lower P/Es.
Each point on the scatter plot below this paragraph represents the P/E on the S&P 500 and the yield on the 10-year Treasury at a single point in time. As can readily be seen, these points generally fall close to the curved trendline. The current P/E / yield point is noted with the red arrow. Today’s divergence is the largest variance away from the trendline. Previous divergences have been met with reversions back to trendline. Therefore, as we look into the future, we could reasonably expect that either interest rates could rise, P/Es could rise or both.
As mentioned above, low interest rates will have implications for investment returns going forward, both for equities and for bonds. Fixed income price appreciation, which accompanies falling interest rates, is a significant component of total return for bond investors. With rates at the low levels detailed above and with little room to fall further, fixed income investors may not be able to count on much in the way of price appreciation over the coming years. As yields start to rise, prices on bonds will begin to fall.
At this point, let’s compare the potential return of two investment alternatives available to investors in the fourth quarter of 2002, the common stock of General Electric (GE) and the 10-year Treasury bond.
GE has historically been able to grow revenues and earnings at a double-digit rate, but for this illustration let’s assume that earnings growth slows to a more conservative 8%. GE currently pays a $.72 per share dividend, yielding 3.3%. The 10-Year Treasury, by comparison, is currently yielding 3.6%. If GE were to grow their dividend at the same pace of their earnings growth, 8%, they would be paying a per share dividend of $1.55 in ten years. Based on its recent $22 price, that dividend yield is 7.1%. Further, if we make the conservative assumption that GE’s dividend yield rises slightly over the next 10 years to 3.5%, we can back into an implied price for GE ten years from now based on the simple formula for calculating dividend yield[1]. Dividing the $1.55 annual dividend by the target 3.5% yield results in a share price expectation of just over $44, double the recent $22 level. In addition, we would have received $11.26 in dividend income over the ten-year period resulting in an annualized return of approximately 10%. In contrast, the 3.6% 10-year Treasury, held for the entire 10-year period, provides a static $3.60 per year in income over the decade and offers no potential for price appreciation. Comparing the two investments, GE’s total return clearly bests the 10-year bond with an annual return three times that of the 10-year Treasury.
Only hindsight will show which investments will have been the best to hold over the coming decade. Will bonds extend their current outperformance, or will stocks of solid companies with the ability to generate free cash flow to support a growing dividend take the day? Just as it was perilous to extrapolate the outlandish equity returns of the late nineties into the new millennium, a degree of caution should be used in extrapolating the recent weakness in equities too far into the future.
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For updated (October 2003) figures in the General Electric vs 10 Year Treasury Analysis, please click here.
[1] Dividend yield = Dividend Rate / Price
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