The reverse yield gap has been reversed
One of the more esoteric anniversaries of 2009 will be that it is 50 years since the establishment of the reverse yield gap, whereby gilts pay more than shares. What a shame it is being celebrated with a return to the pre-1959 era when equities had the higher yield.
The reverse yield gap is the concept on which equity investment is built. Until 27 August 1959, investors had demanded a higher return from shares to compensate for the risk compared with gilts. Companies, it was argued, could cut dividends, abolish them or even go bust: gilts were thus
better and warranted a lower return.
After that summer’s day half a century ago the equity lobby won in arguing that the prospect of rising dividends meant it was worth buying shares on a lower initial yield than gilts that paid fixed returns. The dividend growth outweighed the risk, they argued, and the yields crossed with shares paying less for the first time.
Property yields followed on the basis that rising rents made real estate a better long term hold than fixed gilt yields.
And once pensions funds and insurance companies had bought that argument they rushed to swap their traditional fixed-income bonds for shares, thus helping push share prices higher and equity yields even further below gilt returns.
During the 1950s share prices trebled while gilts lost a third of their value and the reverse yield gap has continued for the succeeding decades, even during bear markets.
Until now. Money yields are again below equity yields. The 4.8 per cent paid on the UK share indices is about a percentage point above the yield on long-term government bonds.
What is this telling us? The recession and credit crunch play their part. Share prices have fallen because of poor profit prospects caused by the economic downturn while the cost of money has been cut to try to provoke a revival.
It is possible markets have lost their rationality, but it is more likely they are telling us that the growth in dividends is over. Low inflation will temper dividend growth in the medium term and a company paying flat dividends is as dull as a government stock paying a fixed interest – but with the additional risk.
The difference between the two yields partly reflects that corporate risk but the danger is not so much default, like Woolworth, but the risk of the income flow being cut. There is now a regular stream of companies cutting or abandoning their payments altogether. The banks were forced to by the government to abolish payments and retailers and pub companies are among those forced to do so by financial prudence.
The 8 per cent yield of the FTSE 100 or All-Share indices is based on companies repeating last year’s payments. Many will not. The fall in share prices raised historic yields but the cut in future dividends will reduce yields again.
Perhaps it was the prospect of reduced payments that helped push down share prices? But it means the reverse yield gap has been reversed for its golden anniversary year.
