TEN-YEAR government bonds effectively set a risk-free rate of return for investors, since these government-backed securities guarantee an investor's initial capital investment.
TEN-YEAR government bonds effectively set a risk-free rate of return for investors, since these government-backed securities guarantee an investor's initial capital investment.
While prices of these listed instruments vary throughout their term as interest rates move up and down, an investor knows that, ultimately, capital is secure at the end of the bond's term. Under 'normal' market conditions, equities (shares) provide a dividend yield lower than the prevailing 10-year government bond yield. Under normal market conditions, with 10-year bonds yielding, say, 5.5 per cent per annum, the stock market might be expected to yield 4.5 per cent pa because over time, investors know that equities will provide a total average annual return of around 12 per cent pa, which might be made up of 7.5 per cent due to capital growth and 4.5 per cent in the form of dividend returns.
However, today, Australian 10-year bonds yield around 5.68 per cent pa, while the ASX top 300 stocks provide a dividend yield, averaging 5.03 per cent pa, a notional discount of about 0.65 per cent pa to the 10-year bond rate and the S&P/ASX Midcaps yield a whopping 7.9 per cent pa. To reiterate, traditionally, low-risk government bonds deliver a lower total rate of return than equities over the long run, with bonds typically returning around 6 per cent pa and higher risk equities delivering a total of 12 per cent pa. Investors buying shares are usually willing to accept a lower running yield in the form of annual dividend payments, in return for ongoing capital growth, as the value of businesses in which they hold equity, rises.
From our recent understanding of stock market history, it seems entirely appropriate that shares will provide a lower annual yield than bonds, since over the long run equities can be demonstrated to offer investors additional returns in the form of capital growth, while bonds, held full term, offer no capital growth.
Well, these assumptions now need to be checked and examined. The impact of franked dividends - where tax paid on profits distributed to shareholders is credited to the shareholder's tax account - means that a dividend yield of, say, 5 per cent pa which is fully franked, is actually a tax effective yield of 7.1 per cent pa to a tax payer on a marginal rate of 30 per cent or more.
Looking closer at the current numbers reveals that, on a like for like basis, the S&P/ASX 300 Index, with an average dividend yield of 5.03 per cent pa, is actually offering a tax effective yield of about 6.1 per cent pa, if the dividends are on average, 50 per cent franked. If we allow for the fact that the average yield of S&P/ASX 300 Index excludes companies making losses and not paying a dividend, the average yield might be closer to 4.7 per cent, which is still a tax effective yield of more than 6 per cent pa, after franking credits. So today's stock market is currently in the aberrant situation of offering a higher effective yield than long bonds.
Analysts calculate what is called a market-risk premium. This premium is factored into the effective cost of servicing equity versus the 10-year government bond rate, based on the volatility of a particular share, compared to the overall market.
The market risk premium equates to the extra risk associated with investment in equities, offset by the premium rate of return expected by investors for depositing savings into equities rather than into 10-year bonds. So, various analysts calculate this premium as being between 2 per cent pa and 6 per cent pa.
The current relative yield of the market versus 10-year bonds indicates that investors expect lower capital growth from shares and are therefore demanding higher yield. In the long term, it is most unusual for shares to offer consistently higher yields than long bonds.
If we go back in time we can see analogies for today's situation. For about eight years following the great Wall Street crash of 1929, equities consistently offered much higher dividend yields than the rates offered on US government long bonds.
The rationale for this was that the risks associated with investment in equities were so highly priced and premium returns so uncertain, that shareholders demanded to be compensated for placing their savings into 'highly risky' shares. Thus, in a situation which is hard to come to grips with, given the past 50 years history of capital appreciation by share markets, listed companies had to offer investors a higher running yield than was offered by government bonds to compensate for the perceived risk of losing capital as shares fell.
So today we have re-entered this zone of low risk tolerance by investors, where making an investment in the stock market is seen as being highly risky.
The potential for outperformance by equities is not seen as being sufficient to compensate for a lower dividend yield.
During the aftermath of October 1987, 10-year bonds had a yield of 13 per cent pa, which goes a long way to explaining the reason why the market crashed. In the downturn of 1991, bonds yielded 11 per cent, so stock market yields were never in danger of eclipsing the risk-free rates.
It is out of periods of uncertainty and heightened risk intolerance that new bull markets are born. By the second quarter of 2009, this bear market will be 20 months old and getting long in the tooth. Briefcase expects that opportunity will begin to arise over the coming six months.
It's a great time to be planning to put together a share portfolio. To an investor, its like being a kid in a candy store, with so many smaller companies and others in the out-of-favour property area offering dividend yields of between 6 and 10 per cent pa, while trading on price to earnings ratios of six to 10 times.
An alert investor can begin by sifting through the recent profit results, discarding and weeding out those companies whose cash flow was not sufficient to support corporate growth and those whose interest cover had fallen below 5 times and whose dividend payout is unsustainable, to leave the absolute gems.
---
Official interest rates have begun to fall in Australia and by April 2009 we should have short rates back at 6.25 per cent pa, while long bonds are likely to settle at 6 per cent pa.
As the US sorts out its banking and housing finance crises, risks associated with equities will begin to subside into the back end of 2009. Briefcase is sure there are still more nightmares to emerge from the US, with the economy there a complete bag of worms.
Briefcase expects to see a crisis in automobile finance. Most cars in the US are leased and not purchased outright. The lessee can simply drive a vehicle back to the car yard and give the keys back, while the car company cannot chase after the customer for loss of income, most of which is covered by insurance, which goes alongside the lease agreement.
More and more car 'owners' in the US will be finding it difficult to keep up with payment terms, while higher fuel costs will motivate many to reduce the number of vehicles that they run, so for many, taking the Hummer back while keeping the Prius begins to make sense.
Meanwhile, the lease finance companies are going backwards. Calculations of residual value will be well over-done, considering the collapse in value for second-hand trucks and SUVs in the US.
These lease finance companies are run by the same bunch of highly ethical dudes who bought us the idea of issuing sub-prime housing loans to people on welfare.
Briefcase holds little hope for a positive outcome and notes that the underlying stock issued by lease finance companies to support their funding activities has collapsed and now trades at about 50 per cent of face value on a good day.
---
- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis. com.au
