Equity Income as Bond Alternative Given Inflation Expectations

As we make our way through 2021, bond investors continue to face the challenge of finding income/cash flow in a world of low interest rates. As a reminder, a bond is simply a loan made by an investor to a borrower who will pay the investor interest over time and then return the principal at a stated date. While the 10yr US Treasury bond rate has had a meaningful increase to start the year from just under 1% to about 1.6%, this interest rate is still at extremely low levels compared to historical context. Bond investors have seen yields drop for close to 40 years now. The drop in yields over these 40 years has resulted in amazing returns for bond investors because as market rates fall, bond prices rise. This inverse relationship between bond prices and interest rates is known as interest rate risk and is defined as the risk a bond’s value could change due to movement in prevailing market rates, shape of the yield curve, and various other interest rate relationships. In addition to interest rate risk, bond investors also face credit default risk, which reflects the borrower’s ability to repay the loan over time. In this piece, we will focus on where to find income and the asymmetric interest rate risk bond investors face today.

Bond prices are inversely related to movements in rates, and as we have seen rates move up, bond values have come under pressure, especially those with longer maturities. Longer term bonds have greater sensitivity to changes in interest rates than short term bonds. Duration is a metric used to gauge this sensitivity measured in years. To illustrate, if a government bond has a duration of 8 (years) and market interest rates move up 1% point (i.e. from 1.6% to 2.6%), then the price of that bond would drop roughly 8%. If we believe that rising rates pose an asymmetric risk (higher risk of interest rates rising than falling) to investors, and we believe they do, then we must ask what factors impact changes in interest rates.

The two main drivers of changes in interest rates are Central Bank policy and market participation. On policy, the Federal Open Market Committee (FOMC) has a dual mandate of full employment and stable prices. As the FOMC strives to move the U.S. back toward full employment, they are targeting the Policy Rate to be 0-0.25% and forecast to stay at that level even until 2023. With the unemployment rate around 6%, we still have a ways to go before reaching full employment. The FOMC has also included language to target an average inflation rate of 2%. In the short term, it appears to us that they are willing to let inflation go above 2% as we have not seen meaningful inflation above that rate the last several years. It seems that the FOMC is not overly concerned with rising inflation as they view some of the recent spike in prices as transitory given supply chain issues coming out of the Covid-19 pandemic. While we do agree on this aspect, we see the incredible growth of the M2 Money Supply playing a key role in higher inflation rates over the next few years.

Over the last year we have seen trillions of dollars of government spending find its way into consumer pockets, resulting in a 25%+ increase in cash in circulation (M2 Money Supply), which compares to the historical average rate of only 6-7% annually dating back to 1960 (chart above). This massive increase will result in too much cash chasing to few goods resulting in inflation. This will reduce the value of bonds as well as push nominal interest rates higher. The nominal interest rate is purely the stated interest rate of a bond (i.e. 1.6% on a 10yr US Treasury bond). Nominal rates need to go higher in order to provide investors with positive real interest rates or real returns. To illustrate, if the nominal interest rate is 1.6% and inflation is 3%, then the real (adjusted for inflation) interest rate is actually -1.4%. This means that when accounting for inflation, bond investors are potentially locking in negative real rates, and losing purchasing power for the safety of a US Treasury bond. Market participants are starting to come to grips with this risk which is why we have seen longer term market rates start to move up this year as the Policy Rate has stayed at 0-0.25%. With the FOMC focused on full employment and staying accommodative, we believe stable prices may be at risk given the level of the M2 Money Supply. We believe this combination significantly increases the risk of upward pressure on market interest rates, and thereby downward pressure on bond values. With this major headwind for bond investors, we believe there are benefits in turning to dividend paying equities as a source of income.

The first reason to look at dividend equities is simply greater income. While the yield on the 10yr treasury bond has just eclipsed the yield on the S&P 500, there are still plenty of equities that generate more income. In the chart below, you will see that roughly 40% of stocks in the S&P 500 have a yield greater than that of the 10yr treasury bond. Equity strategies that screen and weight stocks for dividends can have yields that are almost 2x that of the current 10yr treasury rate. Investors, especially those in retirement, looking for income to meet spending needs can find greater income in dividend paying equities.

If equities can provide greater income in a portfolio, how do they react to changes in interest rates? Rising rates can have their impact on equity returns as they do with bonds. In the data we see that the level of interest rates matters when it comes to how equities behave. The chart below illustrates the correlation between S&P 500 returns and the 10yr treasury rate. In recent years, when the 10yr rate is below 3.6% there tends to be a positive correlation between stock prices and rates, meaning that in most of these environments we saw stock prices rising with rising rates. While there are certainly many other considerations to look at when evaluating the outlook for equities, rising rates alone from these low levels do not seem to present any major concern, yet.

Equities can also provide a hedge against rising inflation. Typically, equities have exhibited higher real, or after inflation, rates of return than bond returns, especially during periods of rising inflation. Part of the reason why equities can be a better inflation hedge than bonds is due to dividend growth typically outpacing or keeping pace with inflation. In the graphic below (source: WisdomTree), we see that dividends have grown by an average of 5.68% per year which is greater than the 3.58% inflation rate going back to 1957. Of particular note, the growth of dividends was able to keep pace with the average inflation rate even in the high inflation periods of the ‘70s and ‘80s.

Make no mistake dividend equities are still equities and carry their own risks. Bonds still have their place in a portfolio for diversification, but, with the prospects of rising rates and inflation, dividend paying equities offer a more attractive option for investors looking for income.