Why Equity markets out perform Bond markets? Part 1

Bond traders and Equity traders are so different! When you meet the two of them in different groups, you wonder how a CIO handles both these animals! Most myths around the world are that ‘Bond traders’ are smarter than their Equity counterparts. Well, lets not get into banana peel area!

Why equity out performs bonds is a very important question, and the MOST important thing that people forget is:

  • as an aggregate this is true over long periods of time
  • however it is possible that over a point to point in time kinda return bonds may outperform
  • the out performance of bonds vs equities should be done on a micro basis very carefully
  • the risk in both the instrument is high, but it is higher in equities in the short run
  • Bond risk in the long run is INFLATION
  • In a bad company equity and bonds are both risky
  • In a good company, equity should give a better return than debt
  • Investor experience in this matter could be different – depending on his own investing skills.

Having enlisted the caveats – or what you should know to understand this, it is easy to understand that equity outperforms because the return on cost of funding via equity must be higher than the potential return an investor will earn on otherwise safe assets. For a business who can earn 6% from a low risk debt instrument it does not make sense to invest my capital in an instrument or entity that might not generate a greater return i.e. 6%+ admin cost of these funds + safety margin + taxes+ profits.

In this sense, equity MUST generate greater returns than credit because it’s not worth the extra risk to issue equity if the alternative is a relatively safe form of borrowing or credit. In the real life it doesn’t play out like this ALWAYS, and surely not in the short term, but since equity is a sufficiently long-term instrument so it will tend to be true over the long-term.

Has any body told you that because of the same set of investors (almost) one day equity returns and debt returns will catch up? Well if you had believed this notion in say 1995 you would still be waiting for this great convergence! The reason for this is basic. Corporate bonds only give owners a fixed rate of income expense paid by the issuing corporate (for this discussion muni bonds and Gsec do not make sense). Equity, gives the owner the full potential profit in the long-term. If we think of equity shares as a bond then, equity has essentially paid a 19% average annual coupon over the last 30 years while high yield bonds have only paid about a 9% coupon. The gap vanished in the past 10 years, but that is a rarity, not the rule. Credit and equity are different types of legal instruments giving the owner different (potential) streams of income. Equity, being the higher risk form of financing, will tend to reward its owners with higher returns over long periods of time.

If you are a HONEST businessman and you are not sure whether you can generate a higher return than the cost of funds, why would you raise funds? In fact if all businessmen were honest, realistic and not OPM GAMBLERS (other people’s money), there should be no NPA. Ask Adani, Anil Ambani, and the big defaulters…

By the way the technique I use to hurt the Bond Manager’s ego is by telling him “my bond returns are a function of the coupon NOT YOUR EFFORTS. If Cholamandalam Investment Finance pays me 11% p.a….my yield depends on Chola paying that consistently, and in Chola not taking too much of credit risk…NOT ON THE BOND MANAGER’s performance. Sure, they do not like it.

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