In this “new normal” world of zero to negative interest rates, where long-term Treasury yields are below the yields of many dividend-paying stocks, are bonds becoming an asset class for capital appreciation and dividend-paying stocks the investment of choice for collecting income?
Year to date through July 11, the 10-year Treasury note has a total return of 8.7%, and the 30-year Treasury has a total return of 21.2%, according to the Ryan Treasury indexes published daily in The Wall Street Journal. The S&P 500, in contrast, has returned just 5.35% during the same period.
“I couldn’t care less what yields are as long as they’re going down,” says Gary Shilling, president of A. Shilling & Co., an investment advisory firm, noting that when bond yields fall, bond prices rise.
Shilling says he has “never” bought Treasuries for yield but for appreciation – “the same reason most investors buy stocks.”
As of the close on Monday, July 11, the yield on the 10-year U.S. Treasury note was 1.43%, about 80 points lower than it was a year ago, and the yield on the 30-year Treasury bond was 2.15%, about 100 basis points lower. Both were just slightly above record lows hit last week.
In contrast, the dividend yield on the S&P was 2.17%, well above the yield on the 10-year Treasury and almost equal to the yield on the 30-year Treasury bond. That hasn’t happened since the financial crisis in late 2008 and 2009.
Given the sharp drop in bond yields, many advisors and strategists say yields can’t fall much further from here, but that was the same refrain heard a year ago when they were almost double what they are today.
Shilling, who has correctly forecast falling bond yield for years, now targets a 1% yield for the 10-year Treasury and 2% for the 30-year Treasury by year-end, citing deflationary trends in the global economy coupled with growing demand for U.S. Treasuries from overseas investors searching for yield and safety along with slowing supply growth.
Demand for Treasuries has been strong during the first half of this year. ETF investors, for example, added a net $67.6 billion to fixed income products, a 91% increase in inflows versus the same period a year ago. U.S. investors added $44 billion to fixed income ETF portfolios while European investors added $17.6 billion.
Shilling expects bonds will outperform stocks on a total return basis because of falling yields and slow earnings and revenue growth in an economy where many corporations have little or no pricing power, but he does own defensive high-yielding equity sectors such as consumer staples and utilities.
Those sectors had been outperforming other industries in the S&P 500 until recently, but they have been lagging since the S&P 500 set a record high on Monday, led by consumer discretionary, tech and industrial stocks.
David Kotok, chairman and chief investment officer of Cumberland Advisors, said he’s “had great results” owning bonds for capital appreciation in client portfolios for the past eight years, but with yields as low as they are now he says, “One has to be very careful about capital appreciation of bonds going forward.” He prefers floating-rate Treasury notes that reset rates weekly.
When asked about forecasts for even lower rates – Allianz Chief Economic Advisor Mohamed El-Erian is also forecasting 1% yield on 10-year Treasury notes – Kotok says, “Rates may go to zero, but I don’t want to take that risk from here for my clients.” They have been rising for the past two trading sessions. Kotok, who invests for total return, is more bullish on stocks than bonds currently and is fully invested in clients’ U.S. stock portfolios. He has a mix of international stock markets, minus the U.K., in clients’ international stock portfolios,
Another option aside from bonds for advisors and investors looking for income are dividend-paying stocks. The yield on the S&P 500 currently is around 2.1% — about the same yield as the 30-year Treasury — but investors seeking total return may want to consider ProShares S&P 500 Dividend Aristocrats Index ETF (NOBL), which invests in those S&P 500 stocks whose dividends have been rising steadily for at least 25 years.
The ETF, based on an index that weights each stock equally, has gained just over 14% year to date compared with 5.4% for the S&P 500. When the S&P 500 lost about 10% during the first six weeks of the year, NOBL lost only about 5%.
“The strongest commitment a company can make is increasing its regularly quarterly dividend, which is a very powerful signal of the stability of the franchise, the business … and a powerful signal that the company might outperform,” says Simeon Hyman, head of investment strategies at ProShares.
He says the strategy works for investors looking for total return as well as investors seeking income without taking on the risks of stretching for yield.
Larry Stein, president of Disciplined Investment Management in Deerfield, Illinois, says, “Holding dividend-paying stocks for income is a reasonable strategy since many stock yields currently exceed those of high-quality bonds, [but] dividend-paying stocks should not be viewed as a bond replacement. They still have the downside potential of other stocks and do not have the diversifying impact of bonds.”
Stein says times are also difficult for bond investors who may be compelled to chase yield, which is not a sound strategy over the long term. “Investors should not be overweighting bonds or stocks now but be little wary on both sides … It’s extraordinary what’s going on right now.”
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