Your Money – Equity vs bonds: Solving the puzzle

Fund managers use bond to earnings yield ratio for determining equity & bond allocation in a portfolio

Your Money – Equity vs bonds: Solving the puzzle
Having said that, for a perspective, it is interesting to look at one parameter to gauge the relative levels of equity and debt markets.

By Joydeep Sen

The allocation to various asset classes like equity, debt, etc., should be done on the basis of your investment objectives, horizon and risk appetite. Portfolio allocation is not about market timing, but time in the market. That is to say, the allocation should not be influenced by the market levels. Having said that, for a perspective, it is interesting to look at one parameter to gauge the relative levels of equity and debt markets.

All the more so, because at the current juncture, there is uncertainty in the equity market due to global growth concerns. There is uncertainty about the bond market as well, as central banks all over the world are hiking rates.

Understanding bonds
The metric we are talking of is bond to earnings yield ratio. Bond yield is measured by the 10-year government bond yield of that country. Earnings yield is the inverse of price-earnings (P/E) ratio. In other words, earnings yield is EPS divided by price. Let’s take an illustration. Let us say, the level of Nifty is 18,000 and the EPS of the 50 companies is 900. We are not going into the complications of whether it is trailing EPS or forward estimates, to keep it simple.

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On these numbers, PE ratio is 20 and earnings yield is 5%. For a ballpark gauge on the relative attractiveness of equity and bond markets, the earnings yield of 5% is to be compared with the 10-year Government Security yield. As long as the 10-year yield is higher, at least as per this theory, it is attractive to invest in bonds.

The underlying theory is, investment in 10-year Government Security is risk-free, as long as you hold till maturity. There is no credit risk in G-Secs any which way. There is market risk in the interim, if interest rates move up. But if you hold till maturity, you are eliminating market risk as well. On equity, taking EPS as the proxy for returns, this is what you will earn (Rs 900 in our example) on your investment of Rs 18,000. In the current context, earnings yield is significantly lower than bond yield. What then, is the argument for investment in equity?

Equity vs bonds
The one aspect missed out in this theory is growth. When you invest in a 10-year bond at a CAGR of say 7.25%, as long as you hold till maturity, your return is fixed at 7.25%. When you invest Rs 18,000 in Nifty for an EPS of Rs 900, over the next 10 years, EPS will grow along with the growth of the economy and the growth of those 50 companies. Which is why, historically, equity has delivered higher returns than bonds. And, this, in spite of bond yield being historically at a premium over earnings yield.

To get a perspective from the discussion above, in the Indian context, bond yield has been at a level, on an average, of 1.5 times over earnings yield. For your purposes, take the PE ratio as prevailing at that point of time and take the inverse of that. As an example, if the PE ratio is 20, earnings yield is 5%. Apply a multiplier of 1.5, i.e., 5% becomes 7.5%. As long as the 10-year G-Sec yield is around 7.5%, it is somewhere around the long-term average level.

The growth in EPS over the next 10 years is built in the multiplier of 1.5. In our illustration, if bond yield is higher than 7.5%, then it is attractive to invest in G-Secs over equity, as per historical standards. To be noted, the ballpark multiplier of 1.5 times is in the Indian context; it would be different in other markets.

At the cost of reiteration, for investors and advisors, the criteria for allocation to equity and debt (or any other asset category) are investment objectives, horizon and risk appetite. Bond to earnings yield ratio is a concept used by fund managers looking at the allocation in a portfolio rather than the suitability for a particular investor. The utility of the concept mentioned here, for you, is that it can be applied at the margin. For fine tuning of your portfolio allocation, you may look at the allocation between equity and debt in light of this metric.

The writer is a corporate trainer and an author

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