Bond Yield vs. Stock Return
Bond yields and stock returns differ in their calculation methods, volatility, and sensitivity to economic cycles. Understanding both is crucial for a comprehensive view of asset allocation.
What Do These Returns Measure?
Bond yield refers to the annualized return when a fixed cash flow (interest and principal) is received at the current price. Yield to maturity (YTM), which assumes the bond is held until maturity, is a common measure. Since it's a promise made at the time of issuance, it's relatively predictable.
Stock return is determined by the sum of price changes (capital gains) and dividends, with expectations for future earnings reflected in the price. While bond interest is a contractual right, stock dividends and price appreciation are not guaranteed but depend on corporate performance. This article is for educational purposes, comparing the characteristics of these two asset classes, and does not recommend specific stocks or purchases.
How Are Returns Calculated?
Bond prices and yields move inversely. If you buy a bond with a face value of $10,000 and a coupon rate of 4% for $9,800, the interest received ($400) is fixed. Therefore, the actual yield will be higher than 4% because the purchase price is lower. When market interest rates rise, existing bond prices fall, and when rates fall, prices rise.
For stocks, expected returns can be estimated based on earnings. If the share price is $100 and EPS is $5, the P/E ratio is 20x, and its inverse, the 'earnings yield,' becomes 5%. This 5% is often compared side-by-side with bond yield to maturity in asset allocation.
Interpretation Criteria: What to Compare With?
The key comparison is with the yield of government bonds, which carry minimal risk. The difference between a stock's earnings yield and the government bond yield is commonly referred to as the equity risk premium. For example, if the earnings yield is 5% and the 10-year government bond yield is 3%, the premium is 2 percentage points, indicating the excess return stocks are expected to provide for taking on additional risk.
When this premium narrows, stocks appear expensive relative to bonds; when it widens, they appear relatively more attractive. However, this is only a relative measure, and it's important to consider that if the government bond yield itself changes, the valuation of the same stock will also change.
In Practice: Role in Asset Allocation
Traditionally, bonds act as an 'anchor' in a portfolio with stable interest and low volatility, while stocks provide long-term growth potential. A common approach is to allocate proportions like 60% stocks and 40% bonds, where the tendency for the two assets to move differently helps reduce overall volatility.
The relative attractiveness of both assets also changes with economic cycles. During periods of falling interest rates, bond prices often rise, and stocks also benefit from lower discount rates. However, when inflation is high, both can be volatile simultaneously. For Korean investors, it's also important to consider that currency fluctuations will impact returns when holding both Korean won-denominated bonds and US stocks.
Pitfalls and Limitations
Comparing earnings yields relies on the assumption that EPS is stable. If earnings decline due to an economic slowdown, even if the P/E ratio remains the same, actual earning power weakens, so a simple numerical comparison can be misleading. Similarly, looking only at the superficial yield of a bond can lead to overlooking risks; lower-rated issuers offer higher interest rates precisely to compensate for increased default risk.
Furthermore, bonds and stocks do not always move inversely. In periods of rapidly rising interest rates, both bond prices and stock prices can fall together, meaning the diversification effect may not work as expected. It's important not to assume that past correlations will persist in the future.
Key Takeaways
First, bond yields move inversely to prices and are compared using yield to maturity, while stock returns can be converted to earnings yield (the inverse of the P/E ratio) for comparison. Second, assess relative attractiveness using the equity risk premium (stock earnings yield minus government bond yield), but do not treat it as an absolute measure.
Third, the reason for combining these two assets is to diversify volatility by exposing the portfolio to different risks, but this effect is not always guaranteed. Determining your asset allocation based on your investment horizon and risk tolerance should precede any numerical comparisons.
Related reading
Get the app
Your watchlist and portfolio, one tap from your home screen — the Margin Call app