The ups and downs of bond and equity yields

As a financial advisor who works with captive insurance companies, I am constantly looking at the markets. Of particular interest is the bond market, the most important part of the investment portfolios for most captives.

Bonds generally represent somewhere from 60 percent to 90 percent of the average captive’s assets. What’s going on in the bond market is therefore of utmost importance.

However, equities are becoming an increasingly important part of a captive’s investment allocation. There are several reasons for this, not only the historically higher average annual returns, but also the dividend yield paid by high quality large-capitalisation equities, particularly on US equities.

On July 31 last year the yield on the S&P 500 Index (the proxy for US large-cap equities) eclipsed the yield paid on the US Treasury 10-year notes (Figure 1). This is, from a historical perspective, an unusual situation.

Figure 1: 20-year yield on S&P 500 vs yield on US Treasury 10-year notes

There were three notable occasions when the S&P had tremendous selloffs: the first was between 2000 and 2003, when the S&P sold off 44 percent and the yield on the US 10 year declined 48 percent in the same time period. This was in the face of the yield on the S&P climbing 51 percent.

The second was between October 2007 and March 2009 when the S&P sold off 56 percent and the yield on the US 10-year declined 56 percent as well. The S&P yield climbed 125 percent in this period.

The third was the selloff in Q4 2018: a much shorter period and not technically a bear market, but the pattern is similar. While the S&P sold off by 20 percent and the yield on the 10-year declined 12 percent, the yield on the S&P 500 increased 20 percent.

Ten-year focus

In the last 10 years the absolute yield on the S&P500 has only been greater than the yield on the US 10-year note five times. In each of those times the S&P proceeded to go off on a tremendous bull run. Conversely the yield on the 10 year “backed up” and went higher.

In mid-November 2008 the yields “crossed” at about 3.3 percent. The S&P bottomed early March 2009 and climbed 48 percent to the end of 2009. In mid-May 2009 the yield on the 10-year returned to “normal” and crossed over at a yield of 3.3 percent.

In this same period of time the S&P sold off, recovered, and appreciated 20 percent from the level of c.752 in November 2008 to c.900 in May 2009.

The “normal” period of May 2009 until the US 10-year yield crossed over to be less than the yield of the S&P 500 in early August 2011 saw the S&P 500 appreciate 49 percent to July 2011, before falling to the early August 2011 crossover point at which the S&P had still increased 24 percent.

From the peak area of July 2011 the yield on the 10-year dropped, crossed under the yield of the S&P 500 and stayed under until it crossed over into “normal” territory again on May 22, 2013 at 2.04 percent. During that time period the S&P 500 appreciated 23 percent.

As the yields remained “normal” the S&P continued to appreciate to c.$2,012 at the beginning of 2016. The return on equities during the “normal” period was 24 percent, when the yields crossed over again into “abnormal” territory at 2.17 percent on January 4, 2016.

The returns on equities in the round trip cycle from “abnormal to normal back to abnormal”, which occurred (as mentioned above) from August 8, 2011 (S&P $1,119) to January 4, 2016 (S&P $2,012), was 80 percent.

The conclusion to draw from this is that any time the yield on treasuries goes below the yield on stocks, either stocks are undervalued or bonds are overvalued—or both.

Figure 2 shows that in 2016 the lines crossed, and 2017 was a tremendous year for the markets, with the S&P 500 up over 18 percent. Again, in 2019 the yields crossed lines (yield on Treasury was less than on the S&P 500) and there was a powerful rally in the markets, with the S&P up over 28 percent in 2019.

Figure 1: 20-year yield on S&P 500 vs yield on US Treasury 10-year notes

All told, from the beginning of 2016, when the yields were “abnormal” to “normal” in 2017 through 2018 to “abnormal” again in 2019 to “normal” again on December 12, 2019, the S&P 500 has appreciated 56 percent.

Jack Meskunas is a financial advisor at Oppenheimer & Co. He can be contacted at: jack.meskunas@opco.com