Debt or equity?

One of the reasons offered by market strategists for continuing to buy equities is that the dividend yield on stocks is considerably higher than that on government bonds. It is hard to argue with this. The one-year expected dividend yield on the FTSE100, for example, is currently 4.7% versus 0.7% on a 12-month government security. Assuming that equity values remain broadly stable, it makes perfect sense to buy equities which yield a 400 basis points premium over bonds. Now imagine the choice is between corporate debt and corporate equity. From an investment perspective the same applies. But from an issuer perspective things look very different.

UK A-rated corporate debt trades at around 1.94% - more than 270 bps below the dividend yield on equities. Companies thus have an incentive to issue debt rather than equity in order to cut the amount they have to shell out each year in order to persuade investors to buy into their company. After all, according to the well-known Modigliani-Miller theorem the company’s valuation is indifferent to whether it is financed by debt or equity. To the extent that the dividend yield represents a measure of a company’s profit that is redistributed back to shareholders, there are good reasons why a company might want to reduce it – perhaps to increase the funds available for investment or simply to raise employees pay (or even simply to hike the CEO’s bonus).

There have been suggestions that this is one reason why equity issuance is beginning to dry up. The evidence is not conclusive but latest data from the London Stock Exchange does point to a reduction in equity capital issuance over the past couple of years. Based on annualised data for the first ten months of 2019, we look set for a second consecutive decline in issuance with a figure which is roughly one-third below the average of the past two decades (chart 1).

It is indeed notable that equity investors have not revised down their expected returns on stocks despite the fact that interest rates have fallen to all-time lows. We can derive this from the formulation of the dividend discount model attributed to Myron Gordon, known as the Gordon growth model. Playing around with the formula, we derive the result that the compensation demanded by the market in exchange for holding the asset and carrying the risks depends on the expected dividend yield[1] and the (constant) growth rate assumed for dividends. Since the latter is a constant, the required rate of return is a positive function of the expected dividend yield. The expectation that dividends will remain high has thus conditioned markets to demand ever-higher returns.

My calculations suggest that UK equity investors require a total return of 9.8%, which is the highest since the immediate aftermath of the financial crisis in early 2009 (chart 2). If we subtract the risk-free rate from our estimate of total expected returns, we derive the equity risk premium. On my calculations, this is somewhere in the region of 9% in the UK which is comfortably the highest rate in the 25 years over which I have calculated the data (chart 3). Back in the 1990s, I puzzled over the fact that the ERP was negative and concluded that this was flashing a signal that investors were overly complacent about market risks. This in turn prompted me to be bearish on equity trends long before the markets actually corrected (in truth I was way too early so it is no great boast). We cannot say the same today: It may be the case that Brexit-related uncertainty has prompted investors to demand a higher premium but since it has been trending upwards for the past 20 years, this is not a particularly good explanation.

But markets may still be complacent about risks, as they were 20 years ago, albeit for different reasons. In short, investors appear to expect that dividends will continue to rise. The high level for the ERP is thus a misleading signal based on the fact that expected returns are rising whilst the risk-free rate continues to fall. But investors may one day be wrong about expectations of continually rising dividends. This could certainly come about if companies decide that they are better served by issuing debt rather than equity finance, thus reducing the amount they need to pay out in dividends. Issuers do not appear to have adjusted to the fact that the traditional discount of equity dividend yields relative to bond yields has flipped and is unlikely to revert any time soon.  But company treasurers must be wondering whether now is the time to do what governments are increasingly prepared to do – use the period of low yields to issue lots more debt.

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[1] The true expected dividend yield is expected dividends relative to the expected price but the Gordon growth model depends on expected dividends relative to the current price which is not quite the same thing. For expository purposes, we nonetheless call this term the expected dividend yield.