Bond yields and earnings yields are two powerful tools for analysts and for asset allocators. They are an important decision point to decide whether the allocation should be made to equity or to debt. Let us first look at how earnings yields differ from bond yields with the help of an earnings yield vs bond yield chart. While interesting the difference between earnings yield and bond yield, let us also look at what is an acceptable gap and how to interpret the gap.
Bond yields versus earnings yields
Here are 4 things you need to know about the two types of yields of relevance in the market...
Bond yields refer to the current yield that is the interest income on the bond divided by the market price of the bond. Earnings yield, on the other hand is the EPS of the stock dividend by the market price of the stock and shows how much the company is yields in the form of EPS returns.
Earnings yields pertain to equities and it is the inverse of the P/E ratio. That means if the company has an earnings yield of 5% then it means that the stock has a P/E ratio of 20 times. P/E ratio looks as the price as an outcome of the P/E Ratio which reflects the valuation of the stock.
Ideally, when bonds yields are higher than the equity yields there should be a flow of funds from equity to bonds. However, it does not work that way since there is also a capital appreciation angle to equities.
Earnings yields is a better measure compared to the Dividend yield because DY ignores the impact that retained earnings of the company have on the growth prospects of the company.
The real linkage of earnings yield and bond yields may be through the BEER
Bond Equity Earnings Yield Ratio (BEER) is actually calculated by dividing the yield of a government bond by the current earnings yield of a stock benchmark in the same market. The benchmark could refer to the Sensex or the Nifty in the Indian context. The earnings yield of the stock market is just the inverse of the price-to-earnings (P/E) ratio, that is, earnings/price. That means an index with a P/E ratio of 20 has an earnings yield of 5% and a stock market with a P/E ratio of 25 will have earnings yield of 4%. The earnings yield is quoted as a percentage and is normally measured for a period of twelve months. For example, if the P/E ratio of the S&P 500 is 25, then the earnings yield is 1/25 = 0.04 (4%). It is easier to compare the earnings yield to bond yields as it is more like comparing apples and apples rather than apples and oranges.
BEER = Bond yields / Index Earnings Yields
The logic behind the BEER ratio is that if stocks are yielding more than bonds, that is, BEER < 1, then stocks are cheap given that more value is being created by investing in equities. As investors increase their demand for stocks, the prices increase, causing P/E ratios to increase. As P/E ratios increase, earnings yield decreases, bringing it more in line with bond yields. This is a very theoretical perspective and markets need not necessarily conform to this argument. On the other hand, if the earnings yield on stocks is less than the yield on Treasury bonds (BEER > 1), the proceeds from the sale of stocks is reinvested in bonds. This results in a decreased P/E ratio and increased earnings yield. Theoretically, a BEER of 1 would indicate equal levels of perceived risk in the bond market and the stock market.
Remember, this may still be a very simplistic definition of under pricing and overpricing of equity and debt. Normally, investors and analysts look for a reasonable spread. Just being more than 1 or less than 1 does not mean anything. You keep a range of 0.75 to 1.25 as the normal range for BEER. It is only when the BEER crosses the range that you need to trigger action and reallocation