Absolute yield gap

What Is Absolute Yield Gap?

The Absolute Yield Gap is a metric used in investment analysis to compare the current income return offered by equities versus that of fixed-income securities, typically government bonds. It quantifies the raw difference between the earnings yield of a stock market index and the yield of a benchmark government bond, serving as a simplified indicator for relative valuation between these two major asset classes. This metric falls under the broader category of investment analysis and can influence decisions related to asset allocation. The Absolute Yield Gap provides a snapshot of which asset class might offer a higher immediate income stream based on current market prices and yields.

History and Origin

The concept of comparing returns from different asset classes, particularly stocks and bonds, has roots in economic thought that predate formal financial models. Early economists and investors intuitively understood that riskier assets should offer a higher potential return than less risky ones. The formalization of comparing equity returns (often via earnings yield or dividend yield) with bond yields became more prominent in the mid-20th century as financial data became more robust and widely available.

Pioneering work by academics and practitioners, such as Roger Ibbotson and Rex Sinquefield, in collecting and analyzing historical asset class returns from the mid-1970s onwards significantly contributed to understanding the long-term performance differences between stocks and bonds. Their research helped solidify the idea that equities historically offered a "premium" over bonds.¹⁰, ¹¹, ¹² This historical analysis laid a foundation for metrics like the Absolute Yield Gap, even though the term itself might not have been in common parlance from the outset. The "Fed Model," an informal framework that compares the earnings yield of a stock index to the yield on a long-term government bond, also embodies the spirit of the Absolute Yield Gap, gaining attention around the late 1990s as a tool for cross-asset comparison, despite never being officially endorsed by the Federal Reserve.⁹

Key Takeaways

• The Absolute Yield Gap measures the direct difference between the earnings yield of a stock market index and the yield of a benchmark bond.
• A positive Absolute Yield Gap suggests equities offer a higher income return than bonds, while a negative gap implies the opposite.
• It serves as a simplified tool for comparing the relative attractiveness of equity markets versus fixed income.
• Changes in the Absolute Yield Gap can signal shifts in market sentiment and perceived risk.

Formula and Calculation

The Absolute Yield Gap is calculated as the difference between the earnings yield of a stock market index and the yield of a government bond, typically a long-term Treasury bond.

The formula is expressed as:

Where:

• Equity Earnings Yield is the inverse of the price-to-earnings ratio (P/E ratio) for a given stock index. It is calculated as Earnings Per Share (EPS) divided by the Market Price Per Share, or more broadly, the total earnings of the index components divided by the total market capitalization of the index.
• Bond Yield refers to the yield-to-maturity of a benchmark government bond, such as a 10-year U.S. Treasury bond. This represents the total return an investor can expect if they hold the bond until maturity, assuming all payments are made as scheduled.

For example, if the S&P 500 has an earnings yield of 4.5% and the 10-year U.S. Treasury bond has a yield of 4.0%, the Absolute Yield Gap would be (4.5% - 4.0% = 0.5%).

Interpreting the Absolute Yield Gap

The interpretation of the Absolute Yield Gap provides insight into the relative attractiveness of equity markets compared to bond yields. A positive Absolute Yield Gap implies that equities, based on their earnings, offer a higher income return than the yield available from a risk-free bond. This could suggest that equities are relatively undervalued compared to bonds, or that investors are demanding a higher expected return from stocks due to their inherent risk. Conversely, a negative Absolute Yield Gap indicates that bond yields are higher than equity earnings yields, which might suggest equities are relatively overvalued or that bonds are offering a more compelling income proposition.

Historically, a consistently positive Absolute Yield Gap (equities yielding more than bonds) was often considered the norm, reflecting the higher risk associated with stocks. However, in periods of low interest rates, this gap has often narrowed or even turned negative, with bond yields at times exceeding earnings yields, leading investors to seek higher returns in equities despite the lower immediate yield.⁸ Analysts frequently monitor trends in the Absolute Yield Gap to gauge shifts in market sentiment and potential reallocation opportunities between stocks and bonds within a diversified portfolio.

Hypothetical Example

Consider a scenario where an investor is evaluating the U.S. stock market against U.S. Treasury bonds.

1. Calculate Equity Earnings Yield: Assume the S&P 500 index has a current price-to-earnings (P/E) ratio of 25x.

   • Equity Earnings Yield = (1 / \text{P/E Ratio} = 1 / 25 = 0.04 \text{ or } 4.0%)

2. Obtain Benchmark Bond Yield: Suppose the current yield on a 10-year U.S. Treasury bond is 3.5%.

3. Calculate Absolute Yield Gap:

   • Absolute Yield Gap = Equity Earnings Yield - Bond Yield
   • Absolute Yield Gap = (4.0% - 3.5% = 0.5%)

In this hypothetical example, the Absolute Yield Gap is positive at 0.5%. This suggests that, based on current earnings, the stock market offers a slightly higher income-based return than a 10-year Treasury bond. An investor might interpret this as equities offering a marginally more attractive current income stream for the risk undertaken, or it could simply reflect market dynamics where equities are priced to deliver a modest premium over the risk-free rate.

Practical Applications

The Absolute Yield Gap is a widely observed metric in financial markets, serving several practical applications for investors and analysts:

• Cross-Asset Valuation: It provides a quick way to compare the relative attractiveness of equity markets versus fixed income. When the gap is large and positive, equities might appear relatively cheap, encouraging a shift from bonds to stocks. Conversely, a negative or shrinking gap could suggest bonds are becoming more appealing.
• Macroeconomic Indicator: Changes in the Absolute Yield Gap can reflect broader macroeconomic conditions and investor expectations. For instance, a narrowing gap where bond yields rise faster than equity yields might signal concerns about inflation or rising interest rates, making bonds more competitive. The Federal Reserve's Financial Stability Report often comments on asset valuations, including the relationship between equity and bond yields, as part of its assessment of overall financial stability.⁶, ⁷
• Investment Strategy: Portfolio managers may use the Absolute Yield Gap as one input in their asset allocation decisions. A significant deviation from historical averages might trigger a re-evaluation of portfolio weightings. For example, if bond yields become notably higher than earnings yields, some investors might shift capital towards bond yields to capture the higher income, especially if they perceive equity upside to be limited.
• Risk Assessment: The gap can offer clues about the perceived risk-reward balance in the market. A very low or negative Absolute Yield Gap may imply that investors are accepting lower immediate returns from equities, possibly due to expectations of strong future economic growth and capital appreciation, even as bond yields climb due to central bank policies, as seen with the European Central Bank's policy decisions influencing bond yields.⁵

Limitations and Criticisms

While the Absolute Yield Gap provides a straightforward comparison, it has several limitations and criticisms:

• Ignores Growth: The most significant critique is that it compares a current income measure (earnings yield) for equities with a total return measure (yield-to-maturity) for bonds. Equity investors expect returns not just from current earnings or dividends, but also from future economic growth and capital appreciation. A bond's yield-to-maturity, on the other hand, already accounts for its expected total return if held to maturity. This fundamental difference means the Absolute Yield Gap doesn't fully capture the forward-looking expectations for equities.⁴
• Dividend vs. Earnings Yield: Sometimes, dividend yield is used for the equity component instead of earnings yield. However, dividend policies vary widely across companies and industries and can be influenced by factors unrelated to underlying profitability, making earnings yield generally a more consistent measure of a company's earning power.
• "Fed Model" Controversy: The informal "Fed Model," which posits a relationship between the S&P 500's earnings yield and the 10-year Treasury yield, has faced considerable academic and practitioner criticism.³ Critics argue that the statistical relationship observed historically does not imply a causal link or that it will hold true in all market environments. The model does not account for changes in inflation expectations, real growth, or the varying risk profiles of different market periods.
• Static Measure: The Absolute Yield Gap is a static, point-in-time measure that doesn't account for dynamic factors such as changes in corporate earnings growth rates, interest rates volatility, or shifts in investor risk aversion. These factors can significantly alter the true relative attractiveness of equities versus bonds over time.
• No Risk Adjustment: The metric does not explicitly adjust for the inherent risk differences between equities and bonds. Equities are generally considered riskier than government bonds, and investors typically demand an equity risk premium (ERP) to compensate for this added risk. The Absolute Yield Gap simply provides the raw difference, without a clear benchmark for what a "fair" or "adequate" gap should be given the varying levels of risk.

Absolute Yield Gap vs. Equity Risk Premium

The Absolute Yield Gap and the Equity Risk Premium (ERP) are related but distinct concepts in finance, both used to assess the relative attractiveness of equities versus bonds. The key difference lies in their definition and how they account for risk and future expectations.

The Absolute Yield Gap is a direct, backward-looking measure that calculates the difference between the earnings yield of a stock market index and the current yield of a benchmark government bond. It focuses on the current income stream or earnings power relative to a fixed-income alternative. It is a simple arithmetic subtraction and does not inherently reflect the compensation for risk or future growth expectations beyond what is implicitly priced into current yields and earnings.

The Equity Risk Premium (ERP), conversely, is the expected return on equities in excess of the risk-free rate. It is a forward-looking concept representing the additional return investors demand for holding a riskier asset (equities) compared to a risk-free asset (like a government bond). While the ERP can be estimated using historical data (historical ERP), it is more commonly used to represent the expected compensation for taking on equity risk. Various models, including dividend discount models or implied ERP from market valuations, are used to estimate this forward-looking premium.¹, ² The ERP directly addresses the risk-reward tradeoff, acknowledging that equities inherently carry more volatility and uncertainty than bonds.

Confusion often arises because the Absolute Yield Gap is sometimes used as a proxy or an input for estimating the ERP. However, the Absolute Yield Gap, by itself, does not fully encapsulate the risk-adjusted return investors anticipate from equities, as it overlooks the potential for capital appreciation and implicitly assumes current earnings yields are sufficient without explicit risk compensation. The ERP is a more encompassing concept that attempts to quantify the additional return required for equity investment given its higher risk profile.

FAQs

What does a high Absolute Yield Gap mean?

A high Absolute Yield Gap (meaning equity earnings yield is significantly higher than bond yield) generally suggests that equities are offering a greater immediate income return relative to bonds. This could indicate that equities are undervalued compared to bonds, or that investors are demanding a larger earnings yield for taking on equity risk.

What does a negative Absolute Yield Gap mean?

A negative Absolute Yield Gap (where the bond yield is higher than the equity earnings yield) implies that bonds are offering a greater current income return than equities. This scenario might suggest that equities are relatively overvalued, or that bond yields have risen significantly, making fixed income a more attractive option purely on an income basis.

How is the Absolute Yield Gap different from the Equity Risk Premium?

While both compare equities and bonds, the Absolute Yield Gap is a simple, backward-looking difference between current earnings yield and bond yield. The Equity Risk Premium is a forward-looking concept that quantifies the expected additional return investors demand from equities as compensation for their higher risk compared to the risk-free rate.

Is the Absolute Yield Gap a reliable indicator for future returns?

The Absolute Yield Gap can offer insights into relative valuation at a specific point in time, but its reliability as a sole predictor of future returns is limited. It does not account for future economic growth in earnings, changes in interest rates, or shifts in market conditions, which are crucial for long-term equity performance. Many analysts use it in conjunction with other metrics for a more comprehensive assessment.