Dividend Investing For Bond Investors – What You Need to Know

 

dividend investingFor decades, treasury bonds provided much higher yields than stocks.  The yield on the S&P 500 has historically averaged 2.11% (1990 thru Oct 2012).  During that same time period, the average yield on the 10 year Treasury has been 5.06% The difference between these two yields has averaged an incredible 2.95%, making bonds the more attractive choice for investors seeking income. However, the yields on bonds have fallen tremendously over this time period and the two yields are now almost the same, both hovering just below two percent. With the income being generated from bonds and stocks being similar, many income investors are now asking themselves would they rather own stocks or bonds.

  To see a list of high yielding CDs go here.  

Bonds – Yield To Maturity

The key to answering this question is understanding how yields are calculated differently for stocks and bonds. In the case of bonds, there are several different measures of yield. The most commonly used is “yield to maturity”, which is really a measure of return on investment. Yield to maturity includes both interest payments and the change in the bond’s value when held to maturity. A bond investor knows exactly their future return on investment when they buy a treasury bond. This certainty is one the benefits of owning bonds. You can learn more about yield to maturity here.

 

Stocks – Dividend Yield

A company’s dividend yield is not a measure of return on investment. Instead it measures the income paid to shareholders over the last 12 months as a percentage of the company’s stock price.  As stock prices can be very volatile, a stock’s yield can be very volatile even if the $ amount of the yield stays consistent over time. Most companies (that pay dividends) try to keep the amount of the dividend payments consistent over time, or raise them on a regular basis.

 

Why the “apples” to “apples” comparison doesn’t work.

There is a measure of bond yields which measures income. Current yield is the interest paid out over the last 12 months divided by the market price of the bond.  However, current yield does not include a vital piece of information, the future capital gain or loss on the bond. As this information is known, it would be a crime to ignore it simply because we don’t have similar information for stocks. Because most bonds are currently trading at a premium to their value at maturity, the current yield is higher than the yield to maturity.

Comparison of Dividend Investing To Bond Interest Payments

Bond Stock
Definitions Of Yield Yield To Maturity -
Return On InvestmentCurrent Yield -
Annual Interest Payment / Price of Bond
Dividends Paid Over Previous 12 Months / Price Of Stock
Can The $ Amount Of Interest Payments Change? No unless the company defaults.* Yes dividend payments can be increased or decreased by the company’s board.
How often are interest / dividend payments made? Typically, individual bonds pay interest semi-annually. Bond funds and ETFs tend to pay monthly. Typically, individual stocks pay dividends quarterly. Stock funds and ETFs tend to pay monthly
How are dividend /  interest payments taxed? Interest income is taxed at the owner ordinary income rate. Qualifying dividend payments are taxed at 15% for everyone, except the ultra-wealthy.
Which pays a higher yield? Intermediate and Long-Term Corporate Bonds Pay A Higher Yield Than Stocks Treasury And Municipal Bonds Have A Similar Yield To Stocks

There are 3 important benefits to dividend investing vs bond investing:

1) While dividend payments can go up or down, they generally rise over time! Over the last twenty years, the yields on the S&P 500 have not changed much, however, the amount of the dividend has dramatically risen along with stock prices. The S&P has more than tripled in value over the last 20 years. In other words, a 2% dividend paid today would be 3 times the dollar value of a 2% dividend paid in 1993. With bonds, there is no ability for the coupon payment to rise in value.

2) Total Return for stocks is likely to be higher than for bonds over the next 30 years.  Even if the yield on corporate bonds is higher than the yield on stocks, the total return on stocks (dividend plus capital gains) is expected by most people to be higher than the total return on bonds.

3) The taxes on dividends are much lower for the middle class. A family which makes $72,500 per year (for individuals its $48,600) will pay 15% tax on dividend income. On bond interest payments, that same family will pay a minimum of 25% tax. Or put another way, a 3% dividend yields is really like 3.3% bond yield after taxes.

 

There are 2 important benefits to bond investing vs. dividend investing.

1) Less Volatility – Bonds prices are less volatile than stock prices. As the recent financial crisis taught us, the stock market can lose 40% in a few months. The bond market lost less than 10% of its value and quickly bounced back.

2) Certainty Of Payments – If your trying to have certainty over future income payments, bonds are much more dependable than stocks.

 

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