There's a gaping gulf between share dividends and gilt yields.
Bonds and shares are completely unlike, yet some investors fail to understand the fundamental differences between them.
Shares are much riskier than bonds
Bonds are fixed-income securities issued by governments, companies and other organisations. In effect, they are company IOUs paying a fixed yearly interest rate (known as a coupon), plus they return your money in full when they mature.
Thus, bonds are 'shaped' a bit like a dumbbell: you put in a lump sum in at the beginning, collect a stream of interest payments, and then get your lump sum back at the end. As bond owners are creditors of a company, they are near the front of the queue when a company becomes insolvent.
On the other hand, shares are much riskier investments. Although shareholders own a company, this ownership doesn't give them too many rights. They can attend the company's annual general meeting and vote on resolutions, but not much else is guaranteed.
Though shareholders may receive dividends from the company (usually two or four times a year), these cash payouts are by no means certain. What's more, when companies get into financial difficulty, shareholders are right at the back of the queue.
Mind the gap
However, until the Fifties, there was a 'yield gap' between higher-yielding shares and lower-yielding Gilts (UK government bonds). In other words, the variable dividends paid by shares provided a greater yield than the fixed income paid by bonds. This was because share income at the time was seen as very uncertain and was, therefore, less highly prized.
However, celebrated investor George Ross Goobey thought this 'yield gap' bizarre, given the potentially greater returns on offer from investing in businesses, rather than bonds. Hence, he moved Imperial Tobacco's (LSE: IMT) pension fund's focus from Gilts to shares and made a fortune.
Thus, for the past 50 years, the market norm has been for shares to yield less than bonds, because of the scope for company dividends to grow over time. This is known as a 'negative' yield gap.
The yield gap goes positive
Right now, we have a positive yield gap, where shares yield considerably more than bonds. In fact, it's not so much a yield gap as a yield gulf or yield abyss.
Earlier this week, 10-year Gilts carried a coupon of 2.2% a year. That's right: in return for the safety of having your money backed by 'the full faith and credit of the British government', you get a measly fixed rate of 2.2% a year. While I'd be delighted to borrow at such a low fixed rate, I'd hate to earn it.
Currently, the FTSE 100 index of elite companies has a forward dividend yield of 3.8%. This means that the positive yield gap is 1.6% a year. However, over the past decade, FTSE 100 dividends have grown, on average, by about 3.3% a year.
In other words, investors would prefer to earn a fixed 2.2% a year than get an income starting at 3.8% a year with the potential to rise over time. Now I'll show you why this attitude is crazy.
2.2% fixed versus 3.8% growing
Let's put £1,000 into two 10-year investments: one paying a fixed yearly return of 2.2% and the other paying a variable 3.8%, rising by 3.3% a year. These are the income streams generated by the two investments (rounded down to the nearest pound):
| Year | Bond | Share |
|---|
| 1 | £22 | £38 |
| 2 | £22 | £39 |
| 3 | £22 | £41 |
| 4 | £22 | £42 |
| 5 | £22 | £43 |
| 6 | £22 | £45 |
| 7 | £22 | £46 |
| 8 | £22 | £48 |
| 9 | £22 | £49 |
| 10 | £22 | £51 |
| Total | £220 | £442 |
As you can see, my hypothetical share pays out more than twice as much income over a decade than the bond does. For this reason alone, I'd buy the share every time.
Now for the bad news: as I said earlier, dividends aren't guaranteed and can be reduced or even cancelled. Of course, my dividends are unlikely to rise by a rock-steady 3.3% a year and could even fall.
However, they'd have to plunge by at least 13% every year before my total income came in below the £220 paid by the bond over 10 years. Even then, my share would still be better than the bond, because its income is higher in the earlier years (and cash in hand is king).
Three possible outcomes
Given this peculiar state of affairs, there are three possible outcomes:
1. Share prices are too low and investors should buy equities.
2. Bond prices are too high and investors should sell bonds.
3. A positive yield gap is the new norm and capitalism is set to revert back to the Fifties.
Personally, I think the third possibility is by far the least likely. Indeed, I believe that bond prices are blowing a huge bubble. At some point, this bubble will burst, causing hundreds of billions of dollars of losses for bondholders.
As for share prices, they look cheap on this and other fundamentals. Even so, with fear stalking the markets, they could yet fall further.
Then again, were the dividend yield for the FTSE 100 to fall to 4.4% (as seen during the depths of the 2008 crisis), this would be an unbelievable opportunity to buy. How often has the FTSE 100 dividend yield been twice the 10-year Gilt yield? Not often in my lifetime (43 years), I'd wager.
Shares with super yields
Right now, you can buy shares in global businesses paying dividends of more than double the 2.2% a year paid by 10-year Gilts.
Here are eight selected 'super-yielders':
These eight super-yielders should produce two to three times the income of a Gilt paying 2.2% over the next 10 years. If not, then I will give up investing and become a monk, because capitalism would be stone dead!
More on the markets
> Cliff owns shares in GSK. The Motley Fool owns shares in BAE Systems, Scottish & Southern, GSK and AstraZeneca.
