Last week I discussed the similarities between triple net real estate investment trusts (REITs) and bonds. While I think bond investors looking for predictable cash flows can certainly look at equities to complement fixed income holdings, it’s probably not appropriate to view them as substitutes. There is inherently more capital risk in owning stocks.
To see a list of high yielding CDs go here.
For many retired investors, a static bond-dominated income combined with low interest rates makes for a challenging combination. Thus traditional bond investors may be enticed by equities offering higher dividend yields and an ongoing opportunity to achieve dividend growth. Escalating income is an important component of a retirement plan, since the silent-but-deadly force of inflation erodes purchase power. While a bond may in many cases provide a higher coupon rate than a stock’s yield, it’s possible, over time, for that stock’s dividend to grow in excess of a bond’s coupon.
The growth of a dividend over time can be measured by a concept known as yield on cost, or YOC. Let’s say tomorrow we buy both a 10-year bond with a coupon of 6 percent and a stock with a yield of 4%. Over the next 10 years that bond will pay us 5% per annum, or 50% over the life of the bond. Our 4% yielding stock grows its dividend 8% a year for the next 10 years. By the end of the 10 years, the compound growth of our stock reaches a whopping 8.64% YOC, while our bond is still paying 6 percent. And we have no idea what rate we’ll be able to buy another bond at.
Of course it’s possible that our stock does not attain 8% growth. It’s possible that it could fall short of that mark or it could do better, either underperforming or eclipsing the YOC number mentioned above.
In any case, equities with solid, recurring cash flows that have shown a historical propensity to raise their dividends could represent a solid alternative to bonds in today’s market. REITs, as we discussed last week, might be considered a solid alternative. But what other kinds of stocks might fall into a class of bond alternatives?
1. Utilities: Electric, natural gas, telephone/communications, and water companies all fall into the class of utilities. Since most people use these services, there is a high level of recurring revenue. And since we typically pay more for the service year after year, the companies are typically able to pass low-to-mid-single-digit dividend growth, sometimes more, on to shareholders.
2. Master Limited Partnerships (MLPs): Many mid-stream energy companies are structured as MLPs. These companies own pipelines that enable the transport of oil, gas, and other liquids. Again, a high level of recurring revenue involved here and many of these companies have shown ability to consistently raise pay outs to investors.
3. Consumer Products Companies: Strong established household brand organizations that provide products that are used frequently by consumers. Paper products, beverages, foodstuffs, personal care products, and perhaps even some retailers could be thrown into this category.
Are Dividend Stocks In A Bubble?
Just like bonds, there are many market observers who tend to feel that the gravitation of individual investors to dividend stocks because of ZIRP has created an overbought situation in the space. While it does seem that many of your “garden variety” dividend stocks are currently trading with premium valuations, I would hardly consider them in the bubble category that technology stocks were in around Y2K.
So while richly-valued dividend stocks may be apt for a re-pricing event at some point, I would doubt that the severity would be anything near what happened to the Nasdaq over a decade ago. I would also opine that continuation of ZIRP will continue to act as a buoy in the matter.
For investors seeking bond alternatives, common stocks with strong, recurring cash flows may be a good place to start. Although there are elevated risks relative to bonds, stocks offer inflation-fighting dividend growth, something bonds don’t offer, which could make them an ideal complement to a portfolio currently heavy with fixed-income.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.