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Stocks vs Bonds: Time for Income Seekers to Ditch Shares, Chase Rising Yields?

Last Updated November 17, 2023 2:37 PM
Giuseppe Ciccomascolo
Last Updated November 17, 2023 2:37 PM

Key Takeaways

  • After years of depression, bonds are experiencing a resurgence among income-seeking investors.
  • This is especially linked to a shift in the monetary policy landscape.
  • Even the safest bonds, like 10-year U.S. Treasuries, offer appealing 4.59% yields.
  • Should income-focused investors consider transitioning from stocks to bonds?

Bonds are making a comeback after years of avoidance by income-seeking investors due to persistently low interest rates suppressing bond yields. However, the shift to a tighter monetary policy since the close of 2021, driven by central banks aiming to control inflation, has altered the landscape.

Even the most secure bonds are now presenting appealing income levels. Presently, the yield on 10-year U.S. Treasuries stands at 4.59%, and short-dated UK gilts offer a slightly higher yield at 4.65%. Corporate bonds, issued by companies, provide even more lucrative options.

In comparison to equities, this income potential appears highly attractive. The average stock in the U.S. S&P 500 index recorded a yield of approximately 1.2% in May this year, before bouncing back.

This prompts a fundamental question: should investors with an income priority consider shifting from stocks to bonds?

Bonds Yields Are Rising

In the aftermath of recent economic upheavals, such as the Covid-19 pandemic and the conflict in Ukraine, numerous high-yield bond issuers are diligently fortifying their financial resilience.

Many companies have focused on bolstering their balance sheets and securing fresh funding from established and emerging credit sources to enhance their financial robustness, as highlighted by Uli Gerhard, manager of BNY Mellon  IM’s Global Short-Dated High Yield Bond Fund.

Amidst the increased leverage spurred by the pandemic, several companies have opted to reduce their debt, resulting in a more favorable liquidity profile and increased cash reserves. The high-intensity sector has witnessed improved financing options, including the rise of private credit, notes Gerhard.

Gerhard further says that many high-yield bond-issuing companies are growing larger and more diversified. Concurrently, credit ratings within the sector have seen improvements as markets stabilized post the sharp sell-off in 2022.

“High yield, especially in the short-dated segment, is currently attractive for various reasons. Interest coverage is at its highest in decades, sector leverage has significantly decreased, there are limited crucial high-yield bonds maturing in the near future, and default rates remain low,” explains the manager.

While sector returns are on the rise, Gerhard emphasizes the importance of meticulous stock selection for success in the market.

Stocks Offer Expanding Dividends Opportunity

However, he emphasizes that for investors with a longer-term horizon, the growth of income is crucial, and this can only be reliably provided by equities. Numerous equity income managers he’s engaged with are projecting dividend growth ranging between 5% and 10% for the upcoming year.

It’s vital to understand that while bond yields fluctuate, the cash value they pay, known as the coupon, remains constant. This characteristic is why bonds are fixed-income investments with a precise deadline. For instance, if a $1 bond pays $0.05 income today, it will yield 5%. A year later, even if the bond price increases to $1.10, the coupon remains $0.05, resulting in a lower yield of 4.54%.

In contrast, dividend payments on equities are not fixed; companies distribute dividends based on their performance. Many companies strive to incrementally raise dividends regularly.

How Yields Work

Yields can sometimes complicate understanding this concept. A $1 share yielding 5% today with a $0.05 dividend may see its yield drop to 4.58% in a year, even if the share price rises to $1.20 and the company offers a $0.055 dividend—an increase in the cash value of income by 10%.

S&P chart
S&P 2022-2023 chart

Nonetheless, the potential for rising dividend income provides value, safeguarding income from the erosive impact of inflation. With inflation still elevated in most advanced economies, this becomes particularly crucial.

A Practical Example

For instance, BP and Shell currently yield 4.4% and 4%, respectively, while HSBC yields 5.4%, Lloyds Banking pays 5.8%, and NatWest offers 6.7%. British American Tobacco and Imperial Brands boast current yields of 9.4% and 8.3%, respectively, with the added benefit of their defensive nature. The insurance sector also presents some noteworthy yields.

Regarding the issue of capital growth, the conventional wisdom suggests that bond prices tend to exhibit less volatility than share prices. In other words, the capital value of bond investments may experience fewer fluctuations than that of equity holdings.

While this rule of thumb may not always hold true, especially in recent years with heightened bond market volatility, it has been a general observation over extended periods.

Inflation And Interest Rates Still Pivotal Factors

Interest rates have remained persistently elevated throughout 2023, with the Federal Reserve (Fed) steadily increasing the short-term interest rate it controls, the federal funds target rate, to a range of 5.25% to 5.50% through July. This has led to higher yields across the bond market. Conversely, equity markets experienced three consecutive months of decline from August to October.

Equity investors are grappling with the impact of a stronger-than-expected economy amid the ongoing challenges of elevated inflation and rising interest rates. In the first seven months of the year, stocks recouped most of the losses from the 2022 bear market, delivering returns exceeding 20%. Yet, the market gave back nearly half of those gains between August and October.

Notably, the bulk of favorable returns this year came from key sectors, particularly those associated with technology-oriented companies.

US interest rates over the years
US interest rates over the years

Inflation reached a peak of 9.1% for the 12-month period ending June 2022, prompting the Fed’s interest rate hikes to curb inflation and stabilize the economy. The aim is to bring inflation closer to the 2% goal without triggering a recession.

Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, acknowledges  modest corporate earnings growth in the third quarter of 2023. However, challenges persist for U.S. corporations. Larger companies, in general, have less need to issue new debt due to previous financing at lower interest rates or sufficient earnings to fund growth needs.

On the other hand, smaller companies may face the choice of reissuing debt at higher costs or delaying significant investments until rates decline. Additionally, utility and real estate companies are sensitive to higher interest rates, encountering more financial obstacles.

Stocks vs Bonds: Making The Right Investment Decision

“As rising interest rates are expected to last longer, an ‘up-in-quality’ approach can help investors identify bond issuers that are well-positioned to withstand higher borrowing costs , together with a more strategic approach to private credit,” Goldman Sachs Asset Management team said .

Investors and asset managers have witnessed a return in returns, but also in dispersion, a factor which highlights, according to the managers, “the value of active management and careful selection”.

“Negative-yielding bonds have shrunk, going from a peak of $18 trillion at the end of 2020 to almost nothing,” the managers observe.

Investors can earn a 4-6% return by funding high-quality companies, double the average for the 2009-2019 period. Fundamentals of the U.S. investment-grade corporate credit market remain strong.

Many companies may be well-positioned to incur higher borrowing costs in 2024. The emerging market corporate bond market is also geared towards investment grade, with a medium rating BBB according to Standard & Poor’s and Fitch metrics, with returns of almost 8%.

“After more than a decade of low rates, investors have begun to recognize that it is not true that there are no alternatives to stocks. Indeed, there are reasonable alternatives, such as core fixed income, including high-quality government bonds.”

In the U.S., fixed income sees more inflows than equities, mirroring a similar trend in Europe. This pattern may persist, with historical trends showing bond flows rebounding post-rate hike cycles. Private credit should be a strength,” writes Ashish Shah, global chief investment officer of public investing at Goldman Sachs AM .

With robust earnings and prudent M&A approaches, investors can find strong risk-adjusted returns in higher-quality credits without venturing into higher risk.

Alexandra Wilson-Elizondo, Deputy Chief Investment Officer at GSAM, suggests capitalizing on higher funding costs by investing in economic cycle winners. Furthermore, she suggests securing excess liquidity premiums and high-quality cash flows, both public and private.

Disclaimer

Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability, and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto user should research multiple viewpoints and be familiar with all local regulations before committing to an investment.

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