Reverse Yield Gap is BACK!
Historically stocks were considered riskier than government bonds, so equities offered a higher dividend yield than the yield on the 10-year Treasury to attract buyers. But beginning in the mid-20th century stock prices rose and bond interest rates climbed to levels higher than dividend yields especially in the late 1970s and early 1980s when inflation was at historically high levels. This was called the reverse yield gap since bonds outyielded stocks.
This reverse yield gap was gradually reduced since the 1980s until it went near level in about 2010 through 2022. The yield gap has grown since then and is now at the highest yield differential since the early 2000s in favor of bonds. It is currently at about 3.7%.
Conclusion
Bond yields have risen significantly since the early 2020s. The pension target return on assets (ROA) has been reduced over this period to about 6.50% for most public plans and about 5.50% for private plans. Investment grade corporate bonds (A and BBB) are yielding near or above 6.00% for long maturities. This suggests that the gap between the ROA and bond yields is near its narrowest in a very long time. Asset allocation should respond with a shift to more fixed income at this appropriate moment in time.
As we have preached for decades, the intrinsic value in bonds is the certainty of its cash flows. Bonds are not performance assets but liquidity assets. We strongly recommend using the bond allocation to fully fund the liability cash flows chronologically through Cash Flow Matching (CFM) with investment grade bonds. In this way you have secured benefits and bought time for the return-seeking assets to grow unencumbered (no cash sweep of dividends needed). We recommend starting with a bond allocation that will fully fund 1-10 years of liability cash flows.
Ryan ALM can do a free analysis of how Cash Flow Matching will secure your benefits at a cost savings of roughly 2% per year (1-10 years = 20%).
Please contact Russ Kamp rkamp@ryanalm.com for more info.
