Dividend yields versus bond yields

Following the recent “once in lifetime” move in credit spreads, an interesting situation now presents itself in some sectors of the market: dividend yields that are greater than bond yields. This now appears to be the case in the Telco, Pharma and Utilities sectors. Of these, the first two arguably present the greatest possible valuation anomaly because the free cash flow generation and corresponding dividend cover are that much greater. The table below shows the dividend yields for the European telco majors versus the yield on a representative 10 year bond. In each case I have selected a bond denominated in the same currency that the share is quoted in. The chart underneath shows the evolution of the relationship over the past 3 years, demonstrating the current situation is quite unusual.




The obvious question then is why this should be so. I think there are two potential explanations:

1) The market expects the dividends to be cut. In the short term this is clearly unlikely, as the cash flow cover for the dividends is substantial. In the longer term there is perhaps a greater likelihood of a cut, particularly if we enter a prolonged deflationary cycle. However, the recent rally would suggest that the markets at least are no longer expecting this outcome (implied inflation from the index linked market has risen this year). Therefore if dividends did end up being cut, the rest of the stock market would presumably get hit much harder.

2) The bonds are mispriced. I am not a bond expert, but I am reliably informed that current investment grade spreads are still pricing a recession, albeit, not the depression that they were implying late last year. Telco bond yields also do not appear to be out of line with other investment grade sectors, so unless the whole market is wrong, I find this explanation unlikely.

Conclusion? Sell Telco bonds and buy Telco equities.