Prior to fifty years ago, dividend yields were always higher than bond yields. It made sense, at the time, that stocks were risky and therefore needed to offer higher current income to entice investors to buy.

Bond yields have been low recently, in what Alan Greenspan called a “conundrum.” It’s clearly visible in the chart above that stock yields, during the depths of the market crash, approached parity with bond yields. Recognizing that stocks offer the potential for capital growth as well as current yield, this situation appeared to be a bargain.

One aspect that is ignored when comparing dividend yields with bond yields is the proportion of free cash flow that is paid as a dividend (versus retained earning), known as the payout ratio.

Equities offer higher free cash flow than can be earned by owning a corporate bond. The proportion that is paid as a dividend becomes current income and the retained earnings, if invested wisely, should translate to future capital growth.

Viewed in this sense, bonds currently appear expensive while stocks appear to present bargains based on present profitability.

Dividend Yield vs. Bond Yield

2 thoughts on “Dividend Yield vs. Bond Yield

  • January 28, 2011 at 4:35 pm
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    The pattern is interesting here… the equity cash flow yield seems like it was elevated for the last decade (maybe due to low interest rates) and it looks like the highest point on the chart is now. Of course since this is scaled by changing interest rates it’s a bit harder to see if it’s actually an unusual yield or just higher than bonds. Seeing historical cash flow for stock market indexes might provide an interesting contrast to the earnings we all know already. But just like earnings aren’t necessarily real, cash flow isn’t necessarily invested wisely 🙂

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  • January 28, 2011 at 4:44 pm
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    True, cash flow isn’t always wisely reinvested, which is why I prefer a (reasonably) higher payout, personally. I feel it’s more democratic.

    As I implied in the article, I think the main reason for the “imbalance” is that bond yields are lower than normal. Either way, it seems reasonable to prefer equities at this point.

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