Mark Fowler: Bonds versus shares - what's better?

Both equities and corporate debt can be traded on the NZX. Photo / Supplied

OPINION:

There is often much debate around the merits of debt investment (bonds) versus equity investment (shares).

In part - how do we measure the relative performance of the two asset classes, particularly when they are, by definition, designed to offer differing benefits?

This question has gained additional importance recently, as unlike the situation which has existed many times in the past, the average equity dividend yield (including imputation credits) in New Zealand is now lower than the average yield to maturity (interest rate) currently offered by the corporate bond market.

The graph below shows this relationship over the last seven years and where we are in the current cycle.

Equity Dividend Yield Divergence

On many metrics, and largely due to the challenging investment environment over the last 12 months, equity markets appear now more reasonably priced, particularly on a price-to-earnings basis.

However, the graph below suggests that bonds now make more sense on a relative value basis, particularly when measured against the current yield to maturity offered from corporate bonds.

If we use a specific example, Ryman Healthcare equity is trading at a price of ~$8.40 and on current forecasts will pay a gross dividend yield of ~2.70 per cent.

The yield to maturity on the Ryman 2.55 per cent December 18, 2026, senior bonds currently equates to ~6.20 per cent.

Now, any equity investor will tell you that you don't own Ryman for the dividend, you own it for the potential capital growth.

This is not an anomaly specific to Ryman however, as I could include Goodman Property and Vector in that analysis - where the companies' projected gross dividend yields will be lower than where the equivalent senior debt yields are trading.

Conclusion

It is important to note that with inflation in NZ running at 7.2 per cent annualised, the debate around real yields sparks a whole different conversation. That is, in most cases, bonds and equities aren't currently providing a positive return when you adjust for inflation.

For the purposes of this article and based on a simple comparison of dividend yield and yield to maturity, NZ debt securities currently appear to offer better value than NZ equity securities, particularly when earnings are projected to stagnate in the near-term.

With interest rate markets now pricing an OCR rate of ~5.40 per cent (currently 3.50 per cent), I think corporate bonds are offering investors a significant opportunity to minimalise volatility and 'lock-in' outright interest levels not seen in a decade.

• Mark Fowler is the Head of Investments at Hobson Wealth. This article contains market commentary and factual information only and does not constitute financial advice.