We have seen several highly-regarded equity commentators recently justify stretched equity market valuations based on depressed government bond yields. Magellan, a manager that we highly regard and respect, recently used the dividend growth model of valuation to demonstrate that lower bond yields can easily justify higher equity valuations. Academically we certainly agree and in a single asset portfolio, such as the Magellan Global Fund, this makes sense. Within our equity allocations, we are happy for Magellan to take this risk on behalf of our clients.
From a broader Asset Allocation perspective, we have issues with the implications of these justifications. Our primary concern of these statements is the inferred positive correlation between equities and bonds. To demonstrate this point, we have deconstructed Magellan’s analysis and applied this to a portfolio consisting of 70% equities and 30% bonds.
For simplicity, we have also been very fortunate to find a company that can grow dividends at 4% p.a. into perpetuity and have applied an equity risk premium of 5%. We have also been extremely fortunate and allocated our bonds in a 10-year bond with a coupon of 5%!
Below we have outlined the capital returns to this portfolio assuming various reductions in the market rate of our bonds from their current 5% and the assumed multiple uplift implied by the dividend growth model:
Portfolio returns look very attractive. As the bond yield falls, we get a large valuation uplift from our equities (assuming multiple expansion implied by the dividend growth model) and a nice valuation uplift from the bond as the present value of the 5% coupon adjusts to the prevailing lower bond rate.
This sequence of returns seen above would somewhat mirror the stellar returns that portfolios have been able to achieve over the past few years.
Where we become concerned is that current bond yields are not at 5%. US 10 Year bonds are just under 2% which justify valuation multiples for our 4% perpetually growing equity of around 33x when using the dividend growth model. For simplicity, we will say that the bond yield is at 2% and demonstrate the impact of bond yields rising from here below again assuming the valuation impact on equities implied by the dividend growth model:
Not quite as pretty a picture, noting that this is a spot in time valuation change so not quite an accurate reflection to the real world.
However, within a wider asset allocation or portfolio construction context we would disagree with adding equity beta to portfolios at the current impasse based off an assumption that low bond yields justify high equity valuations. This is primarily because the inference of the analysis is a perfect correlation exists between bonds and equities.
We do not believe we can forecast the direction of correlations, nor do we believe that we can forecast the direction of interest rates with perfection. However, this analysis demonstrates that justifying equity valuations based on the view of a perpetually low or falling bond yield environment exposes a portfolio to an unbalanced exposure to the counter – a rising bond yield environment.
We are aware of the nuances of bond yields falling (prices rising) in periods of high equity volatility, however, this assessment demonstrates that a period of high equity volatility may well be caused by the increase in bond yields. Perhaps this is an impossibility in the age of QE, MMT or any other acronym for extreme monetary policy or economic theory. Although increasing economic and political uncertainty leaves room for policy error and thus rapid shifts in bond yields and subsequent equity value destruction under this justification.
We prefer to take a different approach, with the protection and preservation of capital at the forefront of our investment decisions. As such, our client portfolios are more diversified than ever across and within asset classes to reduce the reliance on single factors driving return. We remain focused on owning assets or employing managers that have multiple options to drive value.
The Magellan Global fund fits within this mandate for a portion of our equity exposure and couldn’t be happier with their performance and approach, however, this analysis suggests caution when extrapolating single asset valuation justifications to a multi-asset portfolio.
nicely articulated Will
Good stuff Will. Too few investors have owned bonds, the true diversifier of equity risk. I look forward to your next article!
Good article Will, although unfortunately I'm late to the party in reading it. A couple of questions: I take your point about simultaneously higher equity valuations and bond prices from falling interest rates implies a correlation between the two asset classes that many portfolios rely on not being the case, but isn't it true that bonds and equities have not always been counter-correlated? Also, aren't lower interest rates always going to affect equity valuations whether it be from a lower discount rate in a DCF or higher PE (if you accept that lower inflation supports higher PEs)?
Thanks for the Question, @James Weir. You are correct that there have been periods of positive correlation between Bonds and Equities, my point here was more around understanding the risks that you are adding to your portfolio in the construction process. And to your point, if you are relying on the negative correlation to justify the addition of equities beware that this may not persist. I also agree that lower discount rates can lead to higher valuations, but we need to be mindful of this when constructing a portfolio for exactly the reason you point out in your first question. That is, if you rely on low bond yields as your SOLE justification for increasing equities then bond yields must at least maintain that level for your portfolio to maintain its value and therefore what risk are you really adding? Sounds like duration to me, in which case you can just buy long-dated bonds for pure exposure to that factor. Along these lines, I considered the potential for higher volatility from this justification in my follow-up article if you were interested: livewiremarkets.com/wires/higher-volatility-on-the-horizon