Dividend Stocks vs. Bonds

Charlie Toole, CFA, CFP^®

Director of Portfolio Management

This week’s reader question:

What’s your perspective on dividend-income stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company.? With interest rates and bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. as low as they are, do they serve as a good alternative to bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.?

BondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. and dividend-paying stocks both generate passive income to fund retirement spending and achieve other financial objectives. Yet, they are two distinct investment vehicles with differing riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. profiles.

The trade-off is primarily about risk: Bonds are lower risk when compared to stocks, which also means they generally offer lower yields and returns. While dividendA cash payment to investors who own stock in the company. stocks are riskier than bonds, they provide a fairly reliable source of income plus the possibility of capital appreciation over time.

Of course, not all dividend stocks are created equal. I’m a big believer in dividend-growth stocks, which offer a lower yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. compared to high-yield dividend stocks but grow their dividendsA cash payment to investors who own stock in the company. consistently every year.

Dividend-growth stocks have yields that are comparable to bonds. For instance, the Vanguard DividendA cash payment to investors who own stock in the company. Appreciation ETFA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. has a yield of 1.6%. This is better than the yield on the 10-year Treasury bond (currently at 1.3%) and slightly lower than intermediate-term corporate bonds (currently yielding 2.0%).

The real power of these stocks in a portfolio, compared to bonds, is the growth of your income.

For instance, given today’s inflation concerns, many income investors are worried that their purchasing power will erode as costs for everything from food to gas to used cars have been rising. While the income from a bond remains constant, dividend-growth stocks increase their payments to investors. Over the last year, the top 10 stocks in the Vanguard Dividend Appreciation ETF posted a median dividend-growth rate of 9%—that’s almost twice the current rate of inflation.

In addition to growing income, dividend-growth investors participate in the growth of the company’s stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. price over time. So, while you’re collecting that growing income, your principal investment is also increasing.

That makes dividend-growth stocks a no-brainer choice for those seeking income. But before you sell all your bonds, keep in mind that stocks expose you to much greater short-term risk. Bonds are a buffer in your portfolio when the stock market drops. While dividend-growth stocks have historically declined less than other equitiesThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid., their share prices will fall when the overall stock market does. And they’ll fall much further and much faster than bonds.

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