Dividend and earnings yields on many equities now exceed bond yields. Today’s investment professionals have rarely seen this circumstance. This situation is prompting many to eschew bonds in favour of higher stock allocations. In the context of history, this isn’t so unusual but bonds will continue to play key roles for institutional portfolios.
Yield argument in context
Earnings yields on stocks are now about the same as or higher than bond yields, and interest rates are bound to rise as the economy regains more solid footing, which will push bond prices down. Accordingly, the argument goes, buy stocks since they’re the better relative value and likely to be superior long-term performers. Augmenting this view is the perception of many plan sponsors that their unfunded liability problem is not going to be resolved with bonds; therefore an increased allocation to risk assets must be the right solution.
This is intuitive reasoning, but history is not kind to such tactical asset mix shifts. When placed in proper perspective, this is far from a slam dunk.
When looking at Standard & Poors data that compares yields on U.S. stocks with 10-year U.S. Treasury Bond yelds for the past 139 years, earnings yields on stocks exceed bond yields for nearly 100 years. In 1967 that the situation is reversed and since then the two figures have remained reasonably close. This yield argument becomes more questionable when viewed in a long-term context. And, the data are similar when using dividends to measure equity yields.
Bonds expensive but nicely match liabilities
While Canadian bond yields are low at around 3% annually, bonds remain a source of stable income. The main fear of buying bonds today is out of concern for rising interest rates. However, institutions need to remain focused on a goals-based approach to portfolio construction.
While valuations should not be ignored, the first priority should be to match liabilities. This is the reason why some of Canada’s largest pension plans continue to have significant bond allocations, ranging from 23% for OMERS, 26% for the Ontario Teachers’ Pension Plan to more than one third of assets for the Canada Pension Plan and La Caisse de Dépôt.
Limiting losses facilitates quicker recovery
While the typical bond bear market results in single-digit losses (with the worst in the low-teens), the average stock bear market saw a full 33% price decline, spending two to three years under water. So, when it comes to limiting shorter-term losses and volatility, bonds remain key to preserving capital. But perhaps the most striking example of the importance of bonds comes from the Great Depression.
| Stock/Bond Mix (%) | U.S. Great Depression Start End | Peak-Trough Decline | Months to Trough | Months to Recovery | |
| 100/0 | Aug-1929 | Jan-1945 | -83% | 33 | 151 |
| 75/25 | Aug-1929 | Oct-1936 | -72% | 33 | 53 |
| 60/40 | Aug-1929 | Jan-1936 | -62% | 33 | 44 |
| 40/60 | Aug-1929 | Jun-1935 | -45% | 33 | 37 |
| 25/75 | Aug-1929 | Jun-1933 | -28% | 26 | 13 |
From the above table, we see that a portfolio of 100% U.S. stocks (in USD) was under water for more than 15 years, a dozen of which was spent recovering from the bottom. A mere 25% allocation to U.S. bonds cut the time spent in the red by more than half. And a more common 60% stocks, 40% bonds made the trip from top to bottom to recovery in barely more than six years.
Diversification addresses price risk
Diversification can play a role in reducing asset class valuation risk. Diversifying outside of bonds, for example into stocks and cash, can protect capital should bonds enter a weaker period. Similarly, diversifying outside of the stock market worked remarkably well to limit 2007 to 2009 bear market losses. Diversifying within an asset class can also reduce bear market risk.
This means holding a mix of government, provincial, corporate and high yield bonds. This can be accomplished by a single, broadly diversified bond mandate or by obtaining more focused exposure to each of these bond strategies. An allocation to real return bonds may be warranted as a long-term inflation hedge given many institutions have inflation-linked liabilities.
American economist and professional investor Benjamin Graham noted decades ago that all portfolios should have a minimum of 25% in stocks but never more than 75%. The inherent uncertainties of investing, he reasoned, called for an absolute minimum amount of asset class diversification. And Graham’s advice is as relevant today as it’s ever been. Since short-term movements are inherently uncertain, Graham’s excellent advice will serve to keep portfolios from extreme postures.
Greg Rodger is chief investment officer and Dan Hallet is director, asset management for HighView Financial Group.
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