Consider This Before Abandoning Bonds for Bond Equivalents

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Bond investment strategiesIncome-focused investors would be well advised to pay special attention to their inflation-adjusted yields. Over the past several years, plenty of bond investors gave up several opportunities to purchase long-term investment grade debt at yields well in excess of 5%. Instead, too much money was parked in short-term bonds, which provided negative real rates of return. This was done because investors believed interest rates would soon head higher. Whether they realize it or not, bond investors who parked money in short-term bonds have suffered severely, as the opportunity cost of forgoing the higher yields that could have been previously captured continues to mount with each passing day.

Similarly, income-focused investors who switched to the popular ‘ bond equivalent ’ stocks may be suffering opportunity costs that they don’t even realize. In a recent article, I mentioned dividend-cuts as being one of the risks of reallocating from bonds to so-called ‘bond equivalent’ stocks. Another important consideration concerns the yield on cost investors receive from a dividend-paying stock.

For example, if you purchased a dividend-paying stock that pays a 2.50% yield and increases its dividend 5% per year, how long would it take to capture the same amount of income as you would from a longer-term investment grade bond yielding 5%, a preferred stock yielding 6%, or a short-duration junk-bond fund yielding 7%?

In the tables below, I show 20 years of data for the aforementioned scenarios, beginning with stocks:

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After 20 years, the stock originally yielding 2.50% and increasing its dividend 5% per year still hadn’t provided as much income as the 5% yielding bond. In fact, it wasn’t until year 16 that the yield on cost for the stock even surpassed the yield of the bond.

Continuing on, take a look at how much more income could be captured from a 6% fixed yield (preferred stock, for example), or a 7% yield (short duration junk bond fund):

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After 20 years, the dividend-increasing stock still hasn’t begun to provide more annual income than the 6% or 7% yielding fixed-income instruments. Of course, your situation may differ from the examples in this article. I provided the previous examples as food for thought and as a framework under which you can think about your own scenario (also remember to adjust for differing investment tax rates).

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