It's Time to Buy Bonds, Right?

Market narratives are dangerous when they get too far ahead of themselves.

It's easy to look at historically low implied yields for equities and think that bond yields look positively juicy. The price we pay for equities has risen relative to expected earnings, driving down the implied yield. At the same time, bond yields have risen dramatically.

For investors who have lived through the post-GFC yield dearth (negative yields, anyone?), bond yields are appealing. The appeal increases when market narratives compare yields across asset spaces without mentioning the key differences in the metrics. All yields are not created equal.

Here is the observation: Yields of Treasuries, Cash, Corporate bonds and Equities are tightly clustered together (08/29 data).

• Treasury bonds (Bloomberg Treasury Index) = 3.97% 

• Corporate bonds (Bloomberg Corporate Index) = 4.91%

• Cash (1-3 month bills) = 4.21%

• Equities (S&P 500 12 mo forward earnings yield) = 4.11%

This might lead one to conclude that bonds are cheap versus riskier assets like equities. Here are the problems with that simple narrative:

• Comparing equity yields to bond yields is flawed. Bond yields are highly predictive of bond returns and implied equity yields say little about future equity returns.

  
  

• The level of yield convergence is likewise unpredictive of future equity returns: We created a convergence indicator (essentially a cointegration residual) to look at 1) the relationships of yield convergence to forward equity returns and 2) the relationship of convergence to relative forward equity returns (forward equity return versus forward bond returns). Conclusion: Since 1995 there is no correlation between yield convergence and 3-month, 6-month or 12-month S&P500 forward returns or those returns relative to forward bond returns.

There are countless discrete examples that illustrate high convergence of yields does not translate into poor forward equity returns and vice versa. Here are a couple:

• In 1997, average Cash yield 5%, Treasuries 6% and Equities 5% - high convergence: Avg. 12-month forward S&P 500 return was 27%

  
  

• In 2008, average Cash 1.2%, Treasuries 2.8% and Equities 7.2% – low convergence: Avg. 12-month forward S&P 500 return was -16.5%

Some observations:

• The earnings yield of equities is remarkably stable relative to fixed income’s yield volatility. Does this observation help with allocation decisions? Maybe. Maybe not.

  
  

• Historical context matters. The brutal suppression of bond yields by the Fed from 2009 to 2021 contributed massively to the wide spread in asset yields and our perception of the ‘fair value’ of those relationships.

The bottom line: The last 5 years have been a reality check for bonds. The Aggregate bond index is annualizing negative 80 bps. Long treasuries come in close to negative 9% a year.

Bonds might be useful going forward, but just because they’ve been coming up tails for the last 5 years does not mean they are going to start coming up heads.