Reverse yield gap

The reverse yield gap is a financial concept within Investment Analysis that describes an unusual market condition where the average bond yields are higher than average equity yields. This scenario runs contrary to the typical expectation that equities, due to their higher inherent risk, should offer a greater yield than less volatile fixed-income securities. The yield on equities is often measured by the earnings yield or the dividend yield.³⁰, ³¹

History and Origin

Historically, a positive yield gap, where equity yields exceeded bond yields, was considered normal, compensating investors for the higher risk associated with stocks compared to government bonds. However, this relationship began to shift in the mid-20th century. During the 1950s and 1960s, the phenomenon of a "reverse yield gap" became more common in developed markets, notably the United States and the United Kingdom.²⁸, ²⁹ This period saw sustained economic growth and rising inflation, leading investors to increasingly value the capital appreciation potential of stocks over the fixed income stream of bonds.²⁷ The anticipation of future earnings growth and inflation-adjusted returns from equities meant investors were willing to accept a lower immediate yield from stocks. In 1968, as bond yields climbed, market observers noted the "dilemma" for investors choosing between bonds and stocks, highlighting a common reverse yield gap scenario where bond income became notably higher than stock dividends.²⁶ This shift was a significant departure from traditional financial wisdom and marked a re-evaluation of how investors perceived and valued different asset classes.²⁵

Key Takeaways

• A reverse yield gap occurs when the yield on bonds exceeds the yield on equities.²⁴
• It signifies an unusual market condition, as equities typically carry higher risk and are expected to offer a higher yield.²³
• This phenomenon can indicate investor caution about future corporate earnings or broader economic conditions.²²
• The reverse yield gap can impact asset allocation decisions, potentially making high-dividend stocks more attractive than bonds for income-focused investors.²¹
• It can persist for extended periods, especially during low-interest-rate environments or times of economic uncertainty.²⁰

Formula and Calculation

The reverse yield gap is calculated as the difference between the prevailing bond yields and equity yields. While bond yields are generally straightforward (e.g., yield-to-maturity for a long-term government bond), equity yield can be represented by the earnings yield (earnings per share / market price per share) or, less commonly in this context, the dividend yield (annual dividends per share / market price per share).¹⁹

The formula is:

$\text{Reverse Yield Gap} = \text{Bond Yield} - \text{Equity Yield}$

Here:

• Bond Yield: The return an investor receives from investing in fixed income securities, typically long-term government bonds.
• Equity Yield: The return on equities, often measured as earnings yield or dividend yield.

When the result of this calculation is positive, a reverse yield gap exists.¹⁸

Interpreting the Reverse Yield Gap

Interpreting a reverse yield gap involves understanding the underlying market sentiment and economic conditions. A reverse yield gap suggests that investors may be accepting lower immediate returns from stocks due to expectations of future capital appreciation or growth.¹⁷ Conversely, higher interest rates on bonds might make them more appealing for current income, especially if the perceived future growth potential of equities is limited.¹⁶

This condition can also signal investor caution regarding future economic conditions or corporate earnings, as higher bond yields can draw capital away from stocks, suggesting a lack of confidence in future growth or stability.¹⁵ Investors perform valuation comparisons between bonds and stocks; when bonds offer significantly higher yields, it can indicate a belief that stocks are overvalued relative to their income potential, or that future corporate earnings growth will not be sufficient to offset the lower current yield.

Hypothetical Example

Consider a hypothetical market scenario:

• The average yield on 10-year government bonds is 4.5%.
• The average dividend yield for companies listed on the major stock market index is 2.8%.

In this case, the Reverse Yield Gap is calculated as:

$\text{Reverse Yield Gap} = 4.5\% - 2.8\% = 1.7\%$

This 1.7% positive reverse yield gap indicates that bonds are offering a higher current income yield than stocks. This situation might arise if bond yields have risen sharply due to expectations of future inflation or tighter monetary policy, while stock prices have remained relatively high, keeping dividend yields suppressed. Investors looking for immediate income might favor bonds, while those anticipating robust future corporate profits and capital gains might still lean towards equities despite the lower current yield.

Practical Applications

Understanding the reverse yield gap is crucial for investors and policymakers as it offers insights into investor sentiment and the relative attractiveness of different asset classes. For income-focused investors, a significant reverse yield gap might make high-dividend stocks more appealing compared to bonds, influencing portfolio diversification strategies.¹⁴ During periods where bond yields are notably higher than equity earnings yields, investors and analysts compare the two to gauge which asset class offers a better "deal." For example, some analysts look at whether bond yields or equity earnings yields offer the "better bet" for investors.¹³

Moreover, the presence of a reverse yield gap can reflect a lower risk premium demanded by investors for holding equities, possibly due to a belief in the long-term stability and growth of corporate earnings, even if current yields are lower than bond yields.

Limitations and Criticisms

While the reverse yield gap provides a snapshot of the relative income attractiveness of bonds versus equities, it has several limitations. One key criticism is that it primarily considers dividend or earnings yield for equities, which may not fully capture the total return from stocks, particularly capital appreciation.¹² Equities offer the potential for growth in earnings and dividends over time, which can lead to significant long-term returns even if the initial yield is low. Bonds, conversely, offer fixed payments and their value tends to be more sensitive to changes in inflation and monetary policy.¹¹

Some economists and investors also debate the predictive power of the yield gap, particularly concerning future market performance or the onset of an economic recession. The "equity risk premium puzzle" highlights that historically, equities have often outperformed bonds over the long term despite periods where bond yields were higher. This suggests that relying solely on a reverse yield gap for investment decisions without considering other factors like economic growth prospects, corporate earnings outlook, and inflation expectations can be misleading.¹⁰ The relationship between bond yields and equity returns is complex and influenced by a multitude of factors, meaning a reverse yield gap is an indicator, not a definitive predictor. For example, some research suggests that the equity risk premium has been "curiously negative" at times, which implicitly relates to a reverse yield gap where equities offer a lower expected return than bonds.⁹

Reverse Yield Gap vs. Yield Gap

The terms "reverse yield gap" and "Yield Gap" are two sides of the same coin, describing the relationship between bond yields and equity yields.

While the standard yield gap suggests that equities offer a higher yield as compensation for their greater risk compared to the relative safety of bonds, the reverse yield gap flips this dynamic.⁷, ⁸ The confusion arises because both terms deal with the same comparison, but describe opposite outcomes in terms of which asset class provides a higher immediate yield.

FAQs

What causes a reverse yield gap?

A reverse yield gap can be influenced by several factors, including rising interest rates on bonds, which might make fixed-income investments more attractive. It can also occur when there is uncertainty about future corporate earnings or when investors prioritize the stability and income of bonds over the growth potential of equities.⁶ Additionally, periods of high inflation can influence this relationship as investors seek assets that offer protection against the erosion of purchasing power.⁵

Is a reverse yield gap a sign of an undervalued stock market?

Not necessarily. While a reverse yield gap implies that bond yields are higher than earnings yield or dividend yield, it does not inherently mean that the stock market is undervalued.⁴ It could be a reflection of broader economic conditions, such as low confidence in future corporate earnings, or a market environment where investors demand higher current income from stocks due to perceived risks. Investors should consider a wide range of factors, beyond just the reverse yield gap, when assessing market valuations.³

Can a reverse yield gap persist for a long time?

Yes, a reverse yield gap can persist for extended periods. This is often observed in environments characterized by low interest rates or during prolonged economic uncertainty.² Structural changes in the economy or shifts in monetary policy can also contribute to a sustained reverse yield gap.¹ However, market conditions are dynamic, and investors should remain adaptable to evolving economic landscapes.