If Stocks Are Risky, What About Bonds?

June 15, 2016

If Stocks Are Risky, What About Bonds?

  • Yields should be the main factor when choosing whether to invest in bonds or stocks.
  • As yields cannot go much lower, bonds become risky too.
  • Historically any significant increase in bond yields brings to negative returns.

Introduction

It is almost common knowledge that in the long term stocks outperform bonds as bonds are less risky and therefore have lower yields. But if we look at the question from the title of this article from a long term perspective where stocks always outperform, then there is no risk in investing in stocks as eventually you will be rewarded with higher returns. And this is exactly the current market’s perception on the stocks vs. bonds issue.

figure 1 bonds earnings dividends
Figure 1: Dividend yields, bond yields and S&P 500 earnings yield since 1927. Source: Federal Reserve, Multpl, NYU.

Historically the corporate earnings yield was the highest, except for the high inflation period in the 1980s and the dotcom bubble in the late 1990s, early 2000s. We could say that things are finally returning to normal as corporate earnings are higher than bond yields and therefore the logic that stocks will outperform bonds in the long run is correct at the moment.

Stocks did not outperform bonds in times when the earnings yield was lower than the bond yield. 2011 was the first time that bonds outperformed stocks over a 30-year period which is logical as in 1981 bond yields were higher than stock yields. The same has happened since the beginning of this century.

2 figure stock vs bods 21 century
Figure 2: Stocks vs bonds since 2000. Source: Wall Street Journal.

As bond yields were almost double corporate earnings in 2000, bonds smoothly outperformed stocks. We can easily conclude that yields are the main factor in the return puzzle and that investors can expect their returns to be perfectly correlated to the underlying earnings when investing in stocks or to the yields when investing in bonds.

Risks

Bonds are considered much less risky than stocks and if we look at the above figure that is clear as bonds did not experience the swings stocks did. But do not get fooled by bonds and their stable growth as most of the above returns were influenced by declining interest rates. As interest rates decline bond returns increase. The opposite happens if interest rates increase.

3 figure bond yields and returns
Figure 3: Bond returns versus changes in yields from 1927. Source: NYU and author’s calculation.

The almost perfect correlation in the above figure shows that no investment should be made based on general assumptions like the ones that bonds are less risky and that stocks always outperform in the long term. The first thing to look at is the yield of the potential investment, be it stocks or bonds, and then the risk.

The current S&P 500 earnings yield is 4.16% and the 10-year treasury bond yield is 1.62%. By looking at the risk side of the puzzle, it is clear that we are in an asset bubble, as both yields on bonds and stocks are historically low (figure 1). Bond yields have never been below 2% and stock yields are far below the historical mean of 7.42%. The main risk for both assets lies in interest rate increases. As there is no historical precedent to the current low yields and monetary policies, we can only assume an eventual return to normalcy.

As figure 3 shows, any increase in bond yields of 25% from the current yield results in negative returns from 5% to 15% for bonds. At current levels a yield increase of 25% would bring bond yields from 1.61% to just 2.01% and have a negative effect on bond returns. We can only imagine what a 100% bond yield increase would do to bond returns as we have no similar data in the last 90 years to analyze such a situation. A 100% increase in bond yields would bring the current yield to only 3.2% which is still historically very low.

The same can be expected for stock returns because with bond yields going higher, expected stock yields will also be higher and therefore stocks would have to go down.

Conclusion

No one knows what will happen in the future and all that we can make are assumptions based on analysis of historical data. Those assumptions tell us that the risks to an investor by being invested in stocks or bonds are high as both asset classes are in a bubble. If interest rates increase, and eventually they will as that is the goal of every central bank, are you willing to risk 20% of your investment for a yearly 1.6% yield from bonds or 40% for a 4% yield from stocks.

The usual investment tradeoff between bonds and stocks of being overweight the undervalued one and change accordingly might be a good solution. On the other hand, the recent negative yield on the German 10-year note shows how crazy the market can get so that nothing should be excluded but we should properly assess risks.

What Are The Options? 

One option that is usually blasphemy for investors but has to be considered is cash. As most asset classes are overvalued, cash might be a good option to weather the turmoil and give liquidity to buy stocks or bonds at lower prices.

Another option is to find stocks that will outperform the market and perform well in an environment with higher interest rates and inflation. Commodities that are uncorrelated to the economy can be a good protection, as well as utilities with low debt.

All of the above is easy to write about but very difficult to correctly time, but the purpose of this article was not to give exact forecasts and advice, but rather a mere overview of what can happen.

By Sven Carlin Bonds Investiv Daily Stocks Share: