Interest rates in the low tier of investment-grade corporate bonds (Baa-rated by Moody’s) have exceeded the dividend yield on the S&P Composite Index since the 1950s:
Sources: S&P Composite dividend yield is from Robert Shiller’s data set for Irrational Exuberance. Baa rate is from the Federal Reserve Board’s monthly series of Baa rates.
The more interesting value is the spread between the real yield on the S&P Composite and the real rate of interest on Baa-rated bonds:
The spread, in this instance, is measured by subtracting the real S&P yield from the real interest rate. The spread was at or above 5 percentage points most of the time from 1969 to 2009. For reasons I will come to, this led to a significant narrowing of the gap between real, long-term returns on stocks and bonds:
Key assumptions: Current dividends are reinvested in the S&P Composite Index at the current value of the index. Current interest payments are reinvested in new issues of Baa-rated bonds at the then-prevailing interest rate on such bonds. Bonds mature at the end of the 30-year holding period. That holding period was chosen because, according to the St. Louis Fed, “Moody’s tries to include bonds with remaining maturities as close as possible to 30 years. Moody’s drops bonds if the remaining life falls below 20 years, if the bond is susceptible to redemption, or if the rating changes.”
The graph indicates that the “risk premium” for stocks (relative to corporate bonds) has not disappeared, but it has become markedly smaller since the mid-1950s. Why? Because dividend payouts have not kept up with stock prices, and so yields have dropped. This, in turn, has caused stock prices to rise less than they would have had yields not fallen.
Why should falling dividend yields have affected stock prices? The long-run return to stock ownership has two components: price movements and dividends. (By contrast, the bond holder who is in for the long haul expects only to redeem his bonds at face value when they mature.) As dividend yields have shrunk relative to interest rates on corporate bonds, stocks have become somewhat less attractive relative to bonds. The net effect, over the years, has been to reduce the demand for stocks and thus to compound the effect of smaller dividend payouts by causing downward pressure on stock prices, albeit subtly and invisibly.
Yes, stock ownership (on paper) still seems to be a more attractive long-run proposition than bond ownership. But a prudent, risk-averse investor who is willing to buy bonds and hold them to maturity can do quite well without riding the stock-market roller coaster.
Stocks for the Long Run?
Stocks for the Long Run? (Part II)