Valuing bank equities versus bank bonds

CCI has constructed measures of the value of bank equities relative to bank bonds. These measures suggest US bank shares are very expensive relative to bonds, euro area bank shares are broadly in line, and Australian bank equities are expensive.  Mindful that valuation mismatches can last a long time, a scenario analysis suggests Australian bank equities would have to fall about 16-17% to restore fair value relative to bank bonds, although in practice fair value could be achieved by a mix of lower equities and lower bond yields.   

The recent large sell-off in government bonds has seen some analysts highlight that US corporate bond yields now exceed the earnings yield on US stocks for the first time in years.  

For example, the earnings yield for the S&P500 of 5¼% is exceeded by both the Aaa corporate bond yield of about 5½% and the Baa corporate bond yield of about 6½%.   

The comparison between the earnings yield and a corporate bond yield has its roots in the equity risk premium, where the premium is commonly measured by subtracting the government bond yield from the earnings yield, with analysts replacing the risk-free rate with a corporate bond yield.   

However, there are drawbacks to this approach.

One is that the earnings yield is a real concept, such that it should be compared with a real bond yield rather than a nominal bond yield.[1]

Another drawback is that the stock market can have a very different industry mix to a corporate bond yield.  

CCI has addressed these issues in constructing simple equity/bond relative valuation measures for the US, euro area and Australia, focusing on the banking sector.  

This involved comparing like with like by analysing the margin of bank earnings yields over real bank bond yields, where:

• Bank earnings yields were proxied by financial sector earnings yields; and 
• Real bond yields were bank bond yields constructed by CCI's Data Science Team less swap pricing of expected inflation.  

CCI also measured the earnings yield-real bond yield margin using both actual earnings and 1-year-ahead analyst forecast earnings (aka "forward" earnings).  

On this basis, bank equities appear very expensive relative to bank bonds in the US, with the smallest gap between the earnings yield and real bond yield using both actual and forecast earnings since the US was recovering from the global financial crisis.  

In contrast, bank equities in the euro area appear fairly valued relative to bank bonds, in that the gap between the earnings yield and real bond yield is closer to its admittedly short historical average. 

In Australia, bank equities appear expensive relative to bank bonds, with the earnings yield-real bond yield gap broadly at its lowest level in about a decade for both actual and forecast earnings.  

  

Importantly, these simple measures of the value of bank equities relative to bank bonds show that over- and under-valuations regularly persist for some time, with no quick reversion to the mean.  

Mindful of this issue, we used the measures to explore what might happen in a scenario where there was an equity market correction in Australia.

At present, the bank earnings yield-real bond yield gap is 1.3pp below its historic average using actual earnings and 1.5pp lower using forecast earnings.   

In a scenario where the equity market corrected to fully restore margins to their historical averages, the earnings yield would increase by 1.3pp, or 1.5pp using forecast earnings., 

Rising earnings yields mechanically mean that bank price-earnings ratios would decline, with these adjustments suggesting that bank equities are about 16% expensive relative to bank bonds using actual earnings and about 17% expensive using forecast earnings.  

In practice, though, the margins could also be restored by a mix of lower equity prices and lower real bond yields.  

Note:
 [1] For example, the earnings yield = 1/(price/earnings ratio)*100 = nominal earnings/nominal price*100 = (earnings/CPI)/(price/CPI)*100 = real earnings/real price*100.