The risk-reward ratio, or rather one’s perception of it, is the cornerstone of any investment decision. An investment with a high degree of associated risk requires a high expected return for it to be attractive (or indeed, viable) to investors. The greater the risk, the greater the reward.

This is clearly demonstrated when comparing fixed income investments, such as bonds, to equities. If an investor purchased a 10-year government bond with the aim of holding it until maturity, they would have clarity on their expected returns throughout the investment lifecycle. Whereas, the outcome for an equity held for the same period is much less predictable.

Equities, by their nature, can be more sensitive to economic shifts and market movements. However, although there is much that can go “wrong”, there is further potential to outperform.

This reward-for-risk dynamic is captured in the yield gap, a ratio that divides equities’ dividend yield by the yield of long-term government bonds. The higher the yield gap, the better relative value equities are deemed to be. In recent months the yield gap has been narrowing and has now become negligible, meaning bonds and equities are experiencing similar expected return dynamics, with the former having a reduced risk exposure. In short, bonds appear to have a superior risk-return profile.

Mind the gap

As the yield gap has gradually compressed this year, it’s understandable that many investors have sought refuge in fixed income assets.

However, the yield gap has historically been tricky to interpret, particularly when it has narrowed. For instance, in the early 1980s, a yield gap crunch preceded a decade-long run of equity market outperformance. Investors who responded to the crunch by rotating towards fixed income were left rueing missed opportunities.

Notably, the yield gap has often widened in an inflationary environment – with bonds yielding much more than equities. In the high inflation context of the 1970s, equities outpaced bonds. Further, if inflation is to remain high for a long period, as many analysts expect, the real yields of long-duration government bonds are likely to be unattractive or even negative. Together, the lesson of this history is that there is no unerringly normal relationship between bonds and equities.

Cash is king

With this in mind, investors should not necessarily take equities ‘off the table’ in a high inflation, high interest rate environment. Such decisions depend entirely on the individual circumstances of each investor.

Indeed, income-paying equities have historically offered a degree of inflation protection, through dividend growth, that narrows the risk/reward gap to some degree.

These are the focus of The City of London Investment Trust (CTY), managed by Job Curtis with support from David Smith, which has increased its dividend every year since 1966 regardless of market conditions or volatility. In doing so, the Trust – which invests mainly in UK equities with a bias towards large, multinational companies – has provided investors with the comfort of a consistent dividend.

Over the 10 years to 30 June 2023, the Trust’s dividend has grown by 40.6%, outpacing the cumulative effect of inflation, as measured by the Consumer Price Index (CPI) of 33.5%.

The CTY structure reinforces the potentially defensive role of equity income. The fund’s dividends can be bolstered by its internal revenue reserves, smoothing pay-outs across short-term challenges. Moreover, Job has guided CTY to its record-setting annual dividend increases over 32 years of management, through the highs and lows of multiple cycles.

While the narrowing of the yield gap may deter some investors from allocating to anything related to the equity market, the potential protective capabilities of dividend growth should not be discounted wholesale.
 

Past performance does not predict future returns

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