Read of the Day: Dividend Stocks are not an Equal Alternative to Bonds

It’s about time someone wrote this post.  We’ve heard so much in recent years about how low interest rates in fixed income are a good excuse to pile into dividend paying stocks.  As if they’re somehow similar asset classes.  That’s just patently false.  The most destructive comparison is the direct comparison between dividend paying stocks and US Government bonds.  US Government debt is a risk free asset or extremely low risk asset whose income stream  is derived from the most powerful entity on the planet’s ability to tax the most abundant output in the world (of course there is inflation risk, but that’s very different from solvency risk or the likelihood of being made “whole” at maturity).  Equities, on the other hand, represent some of the riskiest assets in the world and derive income over the course of an unreliable and indefinite lifetime.

Anyhow, The Wealth Effect blog has a nice summary of the similarities and important differences:

Here is how I view the similarities and differences between Dividend Paying Stocks and Bonds.

Similarities:

  • Both generate income in a predictable manner (quarterly, semi-annually, etc.).
  • Both require the company to either have cash (profits or reserves) or access to cash (lines of credit) in order to generate the income.

Differences

  • The price of stocks, even dividend paying stocks, generally move more both up and down than bonds. This offers the potential for greater profits but also the potential for greater losses.
  • Stock prices move everyday and there is no point in the future you can point to and know exactly what the price will be whereas barring bankruptcy or other major financial problems, bonds will be redeemed at face value at their maturity date.
  • Income earned as dividends from stocks and income earned as interest from bonds has at times been taxed differently.
  • Dividends can be increased or decreased at the company’s discretion.
    • According to the latest update (October 2012) from the Standard & Poor’s Dividend Report of the over 3,000 dividend paying stocks that trade on major U.S. stock exchanges.
      • 1447 companies have raised their dividends during 2012
      • 124 companies have lowered their dividends during 2012

 

Read more here.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • http://bondsquawk.com Rom

    I totally agree. No matter how you cut it, stocks will always be more volatile than bonds. Comparing bond yields with equity dividends is comparing apples and oranges. They are proxies to each other but should never be thought of as the same due to this risk differential as evident but its price volatility.

  • Geoff

    Cullen, you were very specific in naming “US govt bonds” only. I agree that “US govt bonds” are a unique type of security, at least when viewed from an MR (or MMT) perspective. However, other types of bonds, particularly corporates, are perhaps more worthy of comparing to dividend paying stocks. Credit analysis is very similar to equity analysis.

  • jswede

    Speaking generally….

    If you own a bond and your yield doubles, you lost ~15-20% of principal.

    If you own a dividend stock and your yield doubles, you lost 50%.

  • http://bondsquawk.com Rom

    jswede, on yields doubling for bonds, that is completely dependent on the maturity of the bond which is a factor in determining the price sensitivity or duration of a bond.

    If the yield doubles on a bond that is shorter in maturity, the price drop will be significantly alot less than a bond that is longer in maturity.

    If a 2.5-Year bond with a duration of 2.0 sees a 2% rise in yields, the price falls 4%. If that same increase occurs for a 30-Year bond with a duration of 13.0, the price falls 26%.

  • jswede

    yea – that’s why I said ‘generally’…. in order to be concise I chose a hi-grade intermediate (5-8yr) bond

  • Johnny Evers

    Dividend paying stocks can also generate rising income, as opposed to bonds. A company like Coca Cola has consistently raised its dividend.
    If you took a basket of Dow stocks and compared the bonds to the stocks, the stocks would do much better.
    Stocks have the greater short-term risk, but bonds have the greater long-term risk, which is the greater risk.

  • Geoff

    At least stocks have somewhat symmetric risk in terms of upside and downside. Bond risk is more asymmetric in the sense that it is almost all downside. The upside is limited to the coupon, which is puny at best these days.

    P.S. by downside I mainly mean default, so I’m referring to bonds other than Treasuries.

  • http://bondsquawk.com Rom

    No worries, jswede! =)

  • http://bondsquawk.com Rom

    Geoff, if the upside is limited to just the coupon, then how do you explain the stellar returns of total return bond funds over the past several years? Whether its a fund or an individual bond, if rates fall, bond prices appreciate in addition to the coupon. With a total return approach as opposed to just holding to maturity, you can monetize those gains well before they mature. If you are wondering about liquidity, trading individuals bonds is much easier these days with technology and deep two way markets.

    Also, in terms of bond risk is asymetric, you are right from that measure in isolation. However, you have to remember that the probabilities of that collapse in price that you are referring to is extremely small. According to JP Morgan research, the default rate for High Yield ‘BB’ rated bonds is just over 1.0% in the past 17 years. For Investment Grade, the default rate is alot lower than that obviously (less than 1.0%). So in order to have an asymetrical fall in price for an investment grade bond that you are looking for, you need to have a tail event for that investment grade bond. In other words, the probabilities dictate that a chance of loss is extremely small.

    Also, consider that these probabilities do not include recovery rates. For senior secured bonds, the average recovery rate over the past 17 years is around 50%. So that cuts your supposed asymmetrical downside even more. As an example for BB senior secured High Yield, your actual loss is going to be 0.5% based off of this data.

    To put it simply, if you invested in 100 ‘BB’ bonds with 100 million with 1 mil in each name, only 1 will default based off of history. That defaulted bond will lead to a principal loss of 500k. So what you are left with is 99.5 million. Of course, this doesn’t account for the “puny” income earned which over the course of a year and given today’s levels would be 5-6%. I wouldn’t call that ‘asymmetric’

  • http://www.yourwealtheffect.com Wealth Effect Blogger

    I wrote this article because I didn’t like how a Wall Street firm was pitching stocks as a higher yielding equal replacement for bonds. Bonds and stocks each have their advantages and limitations but in no way should they be viewed as equal alternatives to eachother.

  • Geoff

    Points well taken, Rom. Your defense of high yield bonds would make Michael Milken proud :)

    Regarding total return, I was indeed assuming holding the bond to maturity. I buy the bond at par and I receive par at the end, i.e. no upside. Buying a bond in an attempt to earn a short-term capital gain is not investing as far as I’m concerned. It is trading/speculating.

  • Geoff

    Oops, Cullen would not approve of the way I used “investment”. I guess I should say “allocating long-term savings”?

  • http://bondsquawk.com Rom

    RE: “Your defense of high yield bonds would make Michael Milken proud”

    LOL!

    No worries Geoff. The dividing line between investing and trading is blurry and dependent on each individual’s approach. Good discussion!

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