Yield gap

What Is Yield Gap?

The yield gap is a metric used in investment analysis to compare the returns available from the stock market against those from the bond market. Specifically, it measures the difference between the earnings yield of equities and the yield of long-term government bonds. This comparison provides insights into the relative attractiveness of stocks versus bonds, helping investors make informed investment decisions by highlighting potential imbalances in asset valuations across capital markets.

History and Origin

The concept underpinning the yield gap has roots in the long-standing debate about the relative valuation of stocks and bonds. Economists and financial analysts have historically sought ways to quantify the trade-off between the perceived safety and predictable income of fixed income securities and the growth potential and fluctuating returns of equities. While not attributable to a single inventor, the idea gained prominence as interest rates and inflation became more volatile, prompting closer scrutiny of how these factors influenced the appeal of different asset classes. Academic research, such as studies on the equity risk premium, has explored the historical returns of stocks versus bonds, providing a theoretical framework for understanding this relationship. For instance, the widely cited work by Rajnish Mehra and Edward C. Prescott documented the "equity premium puzzle," noting that equities historically delivered significantly higher returns than risk-free assets, which encouraged ongoing analysis of their relative yields.

Key Takeaways

• The yield gap quantifies the difference between the earnings yield of stocks and the yield of long-term government bonds.
• It serves as a gauge for assessing the relative attractiveness of investing in equities versus fixed-income securities.
• A widening yield gap, where bond yields rise significantly faster than earnings yields, can suggest bonds are becoming more appealing.
• Conversely, a narrowing yield gap, or even a negative gap where earnings yield exceeds bond yield, may indicate stocks offer a more compelling return.
• The metric is influenced by macroeconomic factors like interest rates, inflation, and expectations for economic growth.

Formula and Calculation

The yield gap is typically calculated by subtracting the long-term government bond yield from the earnings yield of a broad equity market index.

The formula is expressed as:

Where:

• Equity Earnings Yield: This is the reciprocal of the price-to-earnings (P/E) ratio, calculated as Earnings Per Share (EPS) divided by Market Price Per Share. For a market index, it's typically the aggregate earnings of the companies in the index divided by their aggregate market capitalization.
• Long-Term Government Bond Yield: This typically refers to the yield on a benchmark government bond, such as the 10-year or 30-year U.S. Treasury bond. The Federal Reserve Bank of St. Louis (FRED) provides historical data for these yields.

For example, if the earnings yield for the S&P 500 is 4.5% and the yield on the 10-year U.S. Treasury bond is 3.0%, the yield gap would be:

Interpreting the Yield Gap

The interpretation of the yield gap provides insights into the relative valuation and potential shifts in investor preference between equities and bonds. A positive yield gap, meaning the equity earnings yield is higher than the bond yield, traditionally suggests that stocks offer a higher potential return per unit of earnings compared to the fixed income return from bonds. This scenario might make equities appear more attractive. Conversely, a negative yield gap, where bond yields exceed equity earnings yields, indicates that bonds offer a higher return for their relative stability and lower risk premium, potentially making them more appealing to investors.

The magnitude of the yield gap also matters. A significantly wide positive gap might suggest equities are undervalued relative to bonds, while a significantly negative gap could signal that bonds are highly attractive or that equities are overvalued. Investors often use this metric to evaluate general market sentiment and allocate capital between the stock market and the bond market.

Hypothetical Example

Consider an investor, Sarah, who is trying to decide whether to allocate more of her portfolio to stocks or bonds. She looks at the current market data:

• The average earnings yield of a broad stock market index is 5.5%.
• The yield on the 10-year U.S. Treasury bond is 4.0%.

Sarah calculates the yield gap:

In this scenario, the yield gap is 1.5%. This positive gap indicates that, based on current earnings and bond yields, stocks are offering a higher potential return than bonds. Sarah might interpret this as a signal that equities are relatively more attractive from a valuation perspective compared to fixed-income investments. However, she understands that this is just one factor in her broader asset allocation decision.

Practical Applications

The yield gap is a versatile tool with several practical applications in financial analysis and strategic asset allocation.

• Relative Valuation: Fund managers and analysts use the yield gap to compare the attractiveness of the equity valuation against corporate bonds and government bonds. A positive yield gap may prompt a closer look at equities, while a negative one could suggest caution for stock investments or a shift towards fixed income.
• Market Timing Indicator: While not a precise timing tool, significant shifts in the yield gap can signal potential turning points in market preferences. For example, a sharp increase in bond yields relative to earnings yields can indicate a growing preference for bonds, potentially leading to equity market corrections. Financial news outlets often report on the implications of changing bond yields for equity markets.
• Risk Assessment: The yield gap implicitly incorporates a form of risk premium assessment. If the yield gap narrows substantially, it suggests that investors are demanding less additional yield (or even accepting less) for the higher risk typically associated with equities, which might indicate a less favorable risk-reward balance in the stock market.
• Economic Outlook: The components of the yield gap—earnings yields (tied to corporate profitability and economic activity) and bond yields (influenced by monetary policy and inflation expectations)—make it a reflector of the broader economic outlook.

Limitations and Criticisms

Despite its utility, the yield gap has several limitations that financial professionals consider.

• Ignores Growth Prospects: The earnings yield is a snapshot of current earnings relative to price and does not explicitly account for future earnings growth. Equities typically offer greater long-term growth potential than bonds, which the yield gap alone does not capture. This can lead to an underestimation of equity attractiveness when growth prospects are strong.
• Different Risk Profiles: Stocks and bonds inherently carry different risk profiles. Stocks involve equity valuation risk, market risk, and business-specific risks, whereas government bonds are often considered near-risk-free in terms of credit risk. The yield gap simply shows a spread without fully normalizing for these fundamental differences in risk and liquidity.
• Accounting Distortions: The earnings yield component can be affected by accounting practices, one-time events, and cyclical factors that temporarily inflate or depress reported earnings, thus distorting the true picture of a company's or market's underlying profitability.
• Monetary Policy Influence: Central bank policies, particularly those impacting interest rates and quantitative easing, can significantly influence bond yields, potentially skewing the yield gap without reflecting fundamental changes in equity valuation or economic health. Analysts and academics often debate the persistent and elusive nature of the equity risk premium, which directly impacts the validity and interpretation of the yield gap.
• Does Not Forecast Returns: The yield gap is a static snapshot and should not be used as a direct predictor of future returns for either asset class. It reflects current conditions, which can change rapidly.

Yield Gap vs. Earnings Yield

The yield gap and earnings yield are related but distinct concepts.

While earnings yield is a component used to calculate the yield gap, the yield gap provides a broader comparative view across asset classes, making it useful for asset allocation decisions. Earnings yield, by contrast, is more focused on evaluating individual stocks or the equity market in isolation.

FAQs

How does the yield gap change with interest rates?

When interest rates rise, bond yields typically increase. If equity earnings yields do not keep pace, the yield gap will narrow, or even become negative, making bonds potentially more attractive relative to stocks. Conversely, falling interest rates tend to widen the yield gap.

Is a positive yield gap always good for stocks?

A positive yield gap suggests that stocks are offering a higher potential return from earnings compared to bonds. While this can indicate stocks are relatively more attractive, it is not a guarantee of future performance. Other factors like economic growth prospects, inflation, and corporate profitability also influence investment decisions.

What is a typical or "normal" yield gap?

There is no universally "normal" yield gap, as it fluctuates with economic cycles, market conditions, and investor sentiment. Historically, equities have often traded with a positive yield gap over government bonds, reflecting the equity risk premium. However, periods of high interest rates or low corporate earnings can lead to a negative yield gap.

Can the yield gap predict market crashes?

The yield gap is an analytical tool for relative valuation, not a direct market-timing or crash prediction indicator. Extreme or rapid changes in the yield gap can signal imbalances or shifts in investor preferences between asset classes, which might precede market volatility, but it does not offer precise predictive power for specific events like crashes.

How is the yield gap used by institutional investors?

Institutional investors utilize the yield gap as one of many metrics for strategic asset allocation and portfolio rebalancing. It helps them assess whether to overweight or underweight equities versus fixed income in their portfolios based on perceived relative value and risk-adjusted returns across capital markets.

References

1. Mehra, Rajnish, and Edward C. Prescott. "The Equity Risk Premium: A Review of the Evidence." NBER Working Paper No. 15090. June 2009. https://www.nber.org/system/files/working_papers/w15090/w15090.pdf
2. Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis. August 9, 2025. https://fred.stlouisfed.org/series/DGS10
3. "Explainer: What does the bond selloff mean for stocks?" Reuters. October 4, 2023. https://www.reuters.com/markets/europe/what-does-bond-selloff-mean-stocks-2023-10-04/
4. Damodaran, Aswath. "Equity Risk Premium: Still a Moving Target." Financial Analysts Journal, Vol. 62, No. 4, July/August 2006, pp. 27-40. CFA Institute. https://www.cfainstitute.org/en/research/financial-analysts-journal/2006/equity-risk-premium-still-moving-target