Bonds and stocks are subject to the same economic conditions, but their prices and yields tell different stories about inflation and growth.

In Canada and many other major markets, government bond yields are at or near record-low levels. This reflects not only the depressed level of central bank policy rates but also bond investor expectations of modest inflation and growth in the future.

Stock markets and, more specifically, dividend-paying stocks tell a different story. Dividend yields on top-quality dividend-paying stocks are at multiyear-high premiums over government bond yields, indicating that investors either expect government bond yields to move considerably higher over the medium term or that dividends will decline.

Both markets can’t be right, but both views have implications for how investors should position their portfolios.

Rates Going Nowhere

The Canadian Central Bank has already cut its policy rate twice this year to support the ailing economy, and with commodity prices in the doldrums and the economy formally in recession, higher short-term interest rates are nowhere to be seen.

Long-term interest rates are at or near 65-year lows. Ten-year Government of Canada bonds now yield 1.43%, and a portfolio of medium-term, investment-grade corporate bonds, 2.69%.

Most economists predict that Canadian rates will remain static until the end of 2016, with only limited increases in the official rate by the second half of 2017. Long-term government bond yields are predicted to rise slowly and end 2017 at just below 3%.

The arguments for and against higher interest rates are equally believable. Prominent investors, such as Bill Gross from Janus Capital, argue that low interest rates damage the economy by discouraging saving. But according to a notable and often quoted study by Ken Rogoff and Carmen Reinhart, periods of financial repression, when interest rates remain below inflation, can prevail for some time, even decades.

Under those conditions, saving is a bad bet, as inflation erodes the purchasing power of money in the bank. Investors must look elsewhere to find assets that offer inflation-beating returns.

Dividends Beat Bond Yields

Compared with low-yielding government and corporate bonds, high-quality stocks that have the potential to consistently grow dividends offer considerably higher dividend yields. For example, our well-diversified Dividend Champions Portfolio currently has a dividend yield of over 4%, with 5% to 10% dividend growth expected per year for the next few years.

You could argue that the risk for stocks is higher than for bonds, and short-term volatility numbers certainly bear that out. But as we have pointed out before (see the September issue of Canadian Edge), dividend-paying equities carry little risk of capital loss for investors who hold those stocks five years or more.

In many developed markets, stock dividend yields are now higher than bond yields. That situation only came about after the 2008 financial crisis. Otherwise, since the 1990s, dividend yields for the most part have been lower than bond yields, reflecting the higher growth potential of stocks and the low risk of capital loss over the long term.

To see the wide gap that has opened up between Canadian stocks and bonds, check out the difference between the dividend yield of one of the country’s highest-quality dividend-paying stocks, BCE Inc. (TSX: BCE, NYSE: BCE), and government bond yields in the graph. In the early 2000s, the dividend yield for BCE stock was considerably lower than that for government bonds.

Stock market investors seem to have concluded that bond yields will eventually move much higher or dividends will decline, making the current high dividend yields an illusion. Of course, it’s possible that dividends for some stocks may decline at some point, but it’s unlikely that the dividend for the Dividend Champions Portfolio will fall even in a tough economy. These stocks were selected mainly for their ability to sustain dividend payments regardless of economic conditions, so the risk of the portfolio’s overall dividend declining is minimal.

Since 2000 the ratio of the BCE dividend yield to that for 10-year Canadian bonds rose steadily at first and then sharply after the financial crisis. The ratio is currently above 3, almost 600% higher than in 2000, when the BCE dividend yield was lower than the government bond yield. If we assume that economists are correct that 10-year bond yields will be 3% by the end of 2017 and that BCE will be able to increase the dividend 5% per year, then the ratio would drop to 1.76 times by the end of 2017, which is still higher than the ratio’s long-term average since 2000.

I can’t say whether the bond or stock market is interpreting the economic environment correctly, but BCE and our Dividend Champions Portfolio reflect conservative assumptions about the odds of long-term interest rates rising. So I’m comfortable holding these stocks long term despite the possibility of short-term headwinds developing if interest rates rise.