For investors, the building of a solid, diversified portfolio is all about choice. Types of choices range from the big picture kind, including the percentage of an overall portfolio pie that will be allocated to specific asset categories, as well as smaller picture choices including investment decisions between similar and not-so-similar securities. One of the major choices that an income investor may be considering today is the choice between a corporate bond and a dividend growth stock.
While bonds are a solution for income investors seeking a static income stream in addition to a guaranteed return of capital on a specified date, the income stream does not grow. Indeed, despite the many benefits to owning bonds, one of the cons is that a lack of payout growth leaves the holder susceptible to ongoing inflationary pressures. Those that extol the virtues of dividend growth stocks often times point to the fact that a growing income stream mitigates the effects of inflation.
So Which Is Better, In General?
In general, I think most investors benefit by having variable exposure to both types of securities. Some income investors may have specific capital preservation needs that behoove primary use of fixed income, whereas others may be in need of income growth, which would point toward more robust dividend equity exposure. Of course there may be some investors that may have a need to be exclusively exposed to one asset.
For others with a more agnostic take on capital preservation and income attainment, I would advise an education on the concept of yield on cost, otherwise referred to as YOC. Yield on cost basically measures the amount of yield growth one achieves with a security over a matter of time. For instance, if I buy XYZ stock today with a dividend yield of 2.5% and that yield grows 8% a year for the next decade, my yield on cost comes out to roughly 5.4 percent. You can calculate yield on cost easily with Internet sites such as this one.
Of course someone looking at today’s corporate bond market might be able to find a 10-year piece of paper that yields in the 5-5.5% range. So if the investment goal is nominal yield attainment, the immediate yield satisfaction of the bond might be preferable to waiting a decade for the equity to rise to the 5.5 level. However, as our bond matures in 10 years, the equity holder continues to reap the potential rewards of dividend growth at a current YOC of 5.4%, while the bondholder is faced with replacing the bond in an indeterminate interest rate climate.
But an 8% dividend growth rate is by no means assured. So even if you think a 2.5% yielding stock you buy today can grow by that amount, actual results could be much less, or optimistically speaking, much better. Your bond’s stated coupon does not change, although open market capital value may fluctuate based on the interest rate climate and the bond issuer’s experience.
In essence, the bond presents a categorically more defined and assured income situation. And though a higher interest rate environment can create opportunity cost for bondholders, only on rare occasions does it lead to capital peril. With dividend growth stocks, both your capital return and income attainment is undefined and unassured, While we can extrapolate expectations through yield on cost, capital and income can fluctuate sometimes in a not so beneficial way.
So Which Is Better, When Looking At Today’s Market?
In my humble view, investors should be cautious on both bonds and dividend stocks, from a tactical return perspective over the near-term. With bond interest not exactly lighting the world on fire and many dividend stocks coming off a 30% move in 2013, and a parallel drop in payout rates, there does not seem to be a generally attractive total return risk/reward proposition existing in today’s yield markets. With Federal Reserve policy acting to create instability in both bonds and interest rate sensitive equity, investors should be prepared for continued above average asset price and yield volatility.
For one either predisposed to invest in income or starved for yield, I don’t see a reason to necessarily fear income securities. However, a ZIRP world and a fluid equity market with, in many cases, significant earnings multiple expansion, has created an environment that both bond and equity investors should be highly attuned to.
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.