Bonds for the Long Run?

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 premiumfor 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.

Related posts:
Stocks for the Long Run?
Stocks for the Long Run? (Part II)

Stocks for the Long Run? (Part II)

In “Stocks for the Long Run?” I say that

unless the course of the regulatory-welfare state is reversed, a prolonged downward shift in the real rate of GDP growth is in the works — probably to about 2 percent. At that rate, expect a continuation of the present trend [since 2000] — stock-price “growth” [adjusted for inflation] of about -4 percent a year.

Be sure to note the minus sign in front of the 4.

Stocks are not bound to rise predictably over time, despite graphs like the next one, which I constructed from the data set cited in “Stocks for the Long Run?”. “Price” (the blue line) traces the real growth in the value of S&P Composite Index; “price + dividends” (the orange line) traces real growth in the value of the S&P Composite Index plus dividends paid on the stocks comprised in the index; “dividends reinvested” (the green line) traces the real value of the S&P Composite Index if dividends had been reinvested in shares of the stocks comprised in the index (green line):

From 1871 through 2010, the average annual increase in the value of the S&P Composite, with dividends reinvested, was 6.7 percent. This kind of hypothetical long-term “return” is cited often as a reason for buying and holding stocks. But a real return of 6.7 percent is not graven in stone, as the following chart indicates.

After a period of decline in the early 1900s, the cumulative rate of return on the S&P Composite, with dividends reinvested, dropped to 5.3 percent in 1920, jumped to 8.3 percent in 1929, plummeted to 5.4 percent in 1932, returned to 7.6 percent in 1966, dipped to 6.2 percent in 1982, climbed back to 7.4 percent in 2000, and (as noted above) dropped to 6.7 percent by the end of 2010. In other words, long-run averages can be moved considerably by short run bouts of what I call “irrational exuberance and rational pessimism.”

Moreover, as a practical matter, the buy-hold-reinvest strategy would not work if there were a massive influx of stock-buyers intent on buying, holding, and reinvesting dividends. They would be chasing illusory returns because massive purchases of stocks would not be rewarded (quickly, at least) by proportionate increases in corporate earnings, which is the main driver of stock prices in the long run. The more likely result would be a bubble — like those of the late 1920s and late 1990s — which would burst, leading to lower stock prices and a greater reluctance to invest in stocks.

More realistic measures of expected returns from buying and holding stocks are depicted by the “price” and “price + dividends” lines. At the end of 2010, the average annual real return on the S&P Composite Index since 1871 was 2 percent. With dividends, the average annual real return was 2.3 percent. But almost no one — not even an institutional investor — is likely to hold stocks in the S&P Composite Index for 140 years.

It makes sense, therefore, to consider shorter holding periods: 10, 20, and 30 years.

If history is any guide, consistently positive real returns on stocks are available only to the relatively rare investor who adheres doggedly to the buy-hold-reinvest strategy for 20 years or longer.

But history is not a reliable guide because — unless the course of the regulatory-welfare state is reversed — the rate of GDP growth will continue to fall, and stock prices are likely to fall in sympathy.

Related posts:
The Price of Government
The Price of Government Redux
The Mega-Depression
As Goes Greece
The Real Burden of Government
The Illusion of Prosperity and Stability
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Why Are Interest Rates So Low?
Economic Growth Since World War II
The Commandeered Economy
Stocks for the Long Run?