Hungry for income? Choice narrows but equities to keep an edge

By Richard Hubbard

LONDON (Reuters) - The unusual premium European equity dividends offer investors over quality corporate bond yields may have peaked as debt markets turn volatile and pressure grows on firms to use their cash.

Any gradual recovery in the economic outlook in coming months, as stimulus efforts by major central banks take hold, is likely to narrow the difference, but the gap will still favor stocks, analysts said.

Companies in the STOXX Europe 600 index carry an average dividend yield of around 2.95 percent compared with a 2.2 percent yield for high-quality corporate bonds tracked by the iBOXX European corporate bond index.

The spread between the two flipped in favor of dividends in mid-2012 for the first time, driven by sharply falling bond yields, and by mid-May 2013 hit 89 basis points where it has since steadied, but the second half of 2013 could be different.

"I believe the spread will tighten in the coming months and I really recommend investors switch into equities," said Roland Kaloyan, global asset allocation strategist at Societe Generale.

Two main factors could drive the spread narrowing.

First, corporate bond yields could rise if safer government debt yields lift from abnormal lows, especially if the U.S. Federal Reserve begins winding up its asset buying. High levels of liquidity are seen likely to prevent any sharp selloff.

Second, Kaloyan said, rising share buybacks and an upsurge in merger and acquisition activity as the recovery gathers strength will make equities more attractive, raising prices and thus reducing the dividend yield.

Kaloyan has calculated that the excess return offered to investors for switching to euro equities from investment grade credit is close to an all-time high and likely to move higher. This trend is already apparent in U.S. stocks, where the so-called "equity risk premium" is at a record high.

"The trend out of credit (corporate bonds) and into equities has already started and should gain momentum in the coming quarters," he said.

European equity dividend yields offering a premium over high-grade corporate debt was unheard of until investors' hunt for return and central bank stimulus began driving bond yields down.

In Europe the premium in favor of dividends first appeared in mid-2012, just before European Central Bank President Mario Draghi drew a line under the euro zone crisis with his "whatever it takes" promise to save the region's single currency.

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Draghi's pledge, and his earlier policies to stabilize the region's fragile banking system, have helped European stocks slowly recover and reduced volatility across the markets.

This fall in volatility is another factor which could drive income investors back into equities and away from credit, by narrowing the gap between the risk-adjusted returns available on both asset classes.

"Volatility across assets in Europe is now below the level we saw through the crisis and back to the 2007 range," John Bilton, European investment strategist at Bank of America Merrill Lynch said.

"This means that while equities can be expected to rise, we are beginning to reach the limit on how far credit can go. I think that is what will cause the spread between the dividend yield and bond yields to come back off the highs," he said.

Bilton said abundant central bank liquidity in the system and a relative lack of supply of good European corporate debt were likely to limit any large move back up in bond yields.

But he added that with the fall in equity market volatility, which increases the prospect of a rise in demand, the outlook was shifting dramatically in favor of stocks.

By measuring risk-adjusted performance, which involves subtracting returns on the safest government bonds from those on equities and dividing by the volatility in a calculation known as the Sharpe ratio, and comparing it with a similar calculation for corporate credit, the change was very clear.

"The Sharpe ratio has swung in favor of stocks: for each unit of risk you can now get more return out of equities than you can out credit for the first time in five years," he said.

(Graphics by Vincent Flasseur, editing by Nigel Stephenson)

Source: http://news.yahoo.com/hungry-income-choice-narrows-equities-keep-edge-134955097.html

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