The Fixed Income Conundrum: Part I Understanding the Challenge
It has been 20 years since the beginning of what was known as the “lost decade” in fixed income. For those too young to have experienced it and as a reminder to those that did, the “misplaced decade” occurred from 2000 to 2009. After a massive run up in large cap U.S. equity prices fueled by the technology bubble of the late 1990s, irrational exuberance subsided, and stock markets crashed. After the smoke cleared, large cap stocks staged a multi-year recovery before hitting the proverbial wall again in the 2007-2008 recession. Despite a strong recovery in 2009, the result was a 10-year return for the S&P 500 Index of -0.95% that is now referred to as the “lost decade.” As students of the market, it is important to recognize that at the start of the lost decade, the S&P 500 Index was trading at such a high valuation that it took 10 years to work it off. The Index came back to life over the next decade to return 13.56% and bring the full 20-year period total return to 6.60%.
As the saying goes, “if you don’t know your history you are doomed to repeat it.” Looking back at historical stock and bond market valuations, we can certainly learn some things to inform our expectations about the future. While we use several different inputs in developing our fixed income expectations for stocks and bonds, we think that valuations, both on an absolute basis and a relative basis, can be an accurate and intuitive way to forecast future performance for both equities and bonds. Simply put, the less we pay for an asset, the more we expect to get out of it relative to history.
Today, we are facing a very different set of circumstances that drive both bond and stock markets. However, the tools used to forecast can still help us frame a solid outlook. In this case, the earnings yield and yield to worst are two of the more impactful valuation data factors that we use in developing our expectations for stocks and bonds, respectively.For example, we can compare the valuation of an index, such as the S&P 500 Index or Bloomberg Barclays Aggregate Bond Index, to other yields and history to get a sense of how we stack up today through relative valuations.Many investors are familiar with the price-to-earnings ratio (PE ratio), which is the price of a share divided by the earnings per share and is used to value stocks. The result is a number that can be compared to other similar companies. The PE ratio can also be a very informative datapoint for determining relative value throughout history.Using those same inputs, the earnings yield is another great valuation metric. Earnings yield (EY) is simply the inverse of the PE ratio, or the earnings divided by the price. Expressed as a percentage, this ratio allows a direct forecast for future returns (for example, a total return forecast could be the current EY plus the expected dividend yield) as well as a comparison of equities to prevailing bond rates. The earnings yield can be a valuable frame of reference when creating market expectations.
Similarly, the yield to worst (YTW) can be used for valuation comparisons with bonds. This is especially true in today’s interest rate surroundings because bond prices are unlikely to benefit from further interest rate declines in our view. The YTW is similar to a bond’s yield to maturity in that both calculations consider the coupon on the bond and the current value. Bonds that do not have call features or optionality will have a yield to maturity that equals its YTW. The yield to maturity accounts for both the coupon payments the investor receives and any gain or loss the investor receives for purchasing the bond at a discount or premium to its par or terminal value at maturity. The YTW measures the same but it adjusts for early calls on the bond’s principal and any difference in the call price versus the bond’s par value. The weighted average yield to worst on a basket of bonds is a good indication of its total return over its holding period.By plotting the valuations and the subsequent performance of an index, we can see a relationship between the variables (exhibit 1). Conceptually, we are gauging how the earnings yield and yield to worst relate to their market returns over time. As you would imagine, the higher the earnings yield and YTW, the greater the probability the stock and bond markets will achieve higher returns over the next a number of years.