MRB's Chart of the Week: playing the great equity income inversion

Income-seeking investors have charged into global bond markets, driving government bond yields to Depression-era levels (into negative territory in some countries). Corporate bond yields have plunged as well, and are at record lows.

For several sectors, however, stock dividend yields are now well above the yields offered by these companies’ corporate bonds (as shown in below).

Such an ‘inversion’ in yields is unprecedented in the past 50 years, and underscores the magnitude of the distortions in the marketplace caused by the lack of economic confidence. 

The good news is that this represents a huge opportunity for investors. The implication of a higher dividend yield relative to corporate bond yields is that investors are anticipating a grim backdrop for corporate profits in the coming years. We do not share such a bleak outcome, and expect global economic prospects to slowly brightening in 2013. 

Favouring dividends

Thus, we see the risk-reward balance as being heavily skewed in favour of dividends over lower yielding coupons. Moreover, dividends can increase, whereas there is no upside in current bond coupons.

In addition, there is no capital gain potential remaining in corporate bonds since yields are already at rock-bottom levels.

MRB still prefers high yield corporate bonds within the fixed income universe, and stocks relative to bonds overall. However, for conservative income-seeking investors, a rotation out of expensive high grade corporate bonds into higher yielding equities offers both an enhancement in income, as well as an excellent total return opportunity for the coming year.