Sharpening Our Views on Income

Brandon Snow's picture

I wanted to pass along some comments from our macro team:

Since the end of the financial crisis, bonds have outperformed equities on a risk-adjusted return basis. We measure risk-adjusted returns via the Sharpe Ratio. Put simply, the higher the Sharpe Ratio the better the reward (i.e. total return) relative to the volatility. However, looking forward, we believe equities have a better balance of risk/reward over bonds.

Source: Bloomberg

First off, monetary tightening (i.e. tapering) should drive bond yields higher and, in turn, bond prices lower. This is why the material rise in bond yields following the introduction of tapering last year by the Federal Reserve caused capital losses among bond funds. Going forward, we believe investing in bonds will likely deliver lower total returns with a risk of higher volatility because of monetary tightening.

Second, in our view the yield on U.S. corporate bonds over U.S. equities (as represented by the S&P 500 Index)  is insufficient to compensate for the above headwinds. Currently, U.S. investment grade bonds earn an average yield of 3.2% annually while the dividend yield on S&P 500 equities averages 2.0%. This is a difference of 1.2% annually, which is near all-time lows over the past two decades.

Source: Bloomberg

Third, it is important to keep in mind that only 33% of every dollar earned as profits by equity holders is paid out as dividends today. The remaining 67% is being reinvested back into the business or used for share repurchases. Both are long-term sources of capital appreciation. In the hands of smart management, both also present significant opportunities for long-term value creation, which is much greater than the 1.2% incremental yield on U.S. corporate bonds.

This third point should not be underestimated. Given the headwinds facing bonds, we believe a superior balance of income, total returns and lower volatility can be achieved by owning equities of high-quality businesses run by well-aligned management teams with a strong track record of capital allocation. On this front, we refer you to a previous blog by Stephen Groff on the Cambridge U.S. Dividend Fund explaining how we are approaching income investing differently.

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