Investing: Dividend Aristocrats Versus Bonds

A few weeks ago, Mel Lindauer expressed his worry that the super-low yields offered by bonds these days have people considering questionable move: switching money out of bonds and into dividend-bearing stocks in a search of more income. “People look around and there’s nowhere to turn,” said Lindauer of the fixed income market. “I’m really concerned. I’m concerned that people are talking about possibly going into equities to get the 2.5% yield and forgetting about the risks in equities.”

Larry Swedroe added his voice to the chorus of concern in his MarketWatch column last week. High-dividend stock strategies “are poor substitutes for either a high-quality bond approach or [a] diversified stock approach,” Swedroe writes, in introducing analysis done by his colleague Jared Kizer.

Kizer argues that a high-dividend strategy is far riskier than a high-quality fixed income approach. In modeling a high-dividend strategy, Kizer finds its lowest one-year return was -36.3 percent, in 2008. Five-year Treasuries, by contrast, never sunk below -5.1 percent.

Further, Kizer argues, you don’t get paid properly for that additional risk. A value-focused investor would get better returns and better risk-adjusted returns investing in stocks with low price to earnings ratios, low price to book value ratios or low price to cash flow ratios, than he would get chasing dividends.

Still, it’s easy to see why investors would be interested in dividends at the moment. While Treasury yields are at rock bottom, and likely to stay there as the Federal government issues the debt “Quantitative Easing Two” will require, corporate dividends are on the march.

In October, USA Today’s Matt Krantz reported:

299 companies increased their dividends during the third quarter, an increase of 56% from the same time last year, according to an analysis of dividends at 7,000 publicly traded companies by Standard & Poor’s. Meanwhile, 35 companies cut their dividends during the quarter, a 74% decrease from the third quarter of 2009. “The bleeding in dividends has stopped,” says S&P’s Howard Silverblatt. “The numbers are going up.”

General Electric (GE) and Microsoft (MSFT) are among the companies that have put in major dividend increases this year. For GE it was a dividend comeback. The company slashed its quarterly dividend almost 70% early in 2009, to 10 cents a share from 31 cents. This year the Fairfield, CT-based conglomerate has increased its rate twice and is now paying 14 cents a share. Seattle software king, Microsoft increased its quarterly dividend 23% in September, and now pays out 16 cents each quarter.

In a recent post on Seeking Alpha, Roger Nussbaum acknowledges the appeal of dividends, noting that drug giant Johnson and Johnson (JNJ)  recently issued 10-year paper at 2.95%, while its common stock yields more, around 3.5%.

Still Nussbaum, like Swedroe and Lindauer, is no fan of substituting high dividend stocks for bonds. His main issue: the underlying value of the stocks proffering these yields can swing wildly. While the odds of bond default on a high quality corporation’s debt is slim, the changes of a steep stock drop are not.  Semiconductor maker Maxim Integrated Products (MXIM) offers a 5.0% yield, but the stock has traded as low as 60% off its high. Drug maker Eli Lilly (LLY) has an even-better 5.50% yield, but it’s been known to fall 50%. AT&T (T) offers a 6.0% yield, and a historical 40% drop.

As a commenter on a lively Bogelhead’s debate on this topic notes, companies are free to cut out their dividend entirely at any time.  Even the Dividend Aristocrats, the index of 42 stocks with 25 years or more of steady dividend increases, (J&J is one) has drop outs. Last year 10 companies fell out, including General Electric.

Defaulting on a bond is a far more complicated matter than just calling a board meeting.

Bottom line: all yields are not created equal.

 

4 thoughts on “Investing: Dividend Aristocrats Versus Bonds

  1. Pingback: Tweets that mention Investing: Dividend Aristocrats Versus Bonds « Portfolioist.com -- Topsy.com

  2. Geoff Considine

    The concern that some investors are chasing yield in moving from safe bonds to risky stocks is legitimate, but this does not mean that there may not be some good reasons to be investing in high yield stocks. A number of people have noted that in investors’ quest for ‘safety’ they have driven yields of many classes of bonds really low. This as made equity look more attractive relative to debt. Extreme risk aversion has perhaps created an environment in which equity dividends are quite attractive. It is totally rational to shorten up your duration on bonds and then buy high dividend stocks to create a portfolio with similar overall risk but higher dividends.

    On the other hand, I think that part of Mel’s point is that investors are not cognizant of risk levels and thus may be inadvertently making their portfolios considerably more risky by selling bonds and buying high yield stocks.

  3. Dennis j Liverett

    Ms. Byrnes 
    I enjoy your blog throughly and find it has valuable discussions with great insight. Please keep up the good work.

    While i believe it is done, i would find to recommend a dividend strategy as a substitute for high quality bonds.  In regards to the high dividend strategy: if the investor is aware of the volatility, and  they are long while enjoying the consistent dividend (which are generally found in high quality firms), why would this strategy not work for someone looking to boost the income in their portfolio? Again, not suggesting outright bond replacement, but as a incremental replacement) Why shouldn’t they assume the risk if able and willingly so for better yield?this assumes it fits their time horizon, which most cases is somewhere south of 50 years!

    Also, using a value approach, a dividend yield can be had at a much higher rate if purchased at the right price. And not subject to interest rate risk. I agree dividends are much easier to take away. But again, the quality required to pay such dividends does have an effect on default risk compared to an equal yield in a bond of lower quality.

    While it wasn’t an apples to apples comparison to begin with, the high dividend strategy does have merit, wouldn’t you agree?

    I would love to hear your thoughts on this.

  4. Nanette Byrnes Post author

    Thanks for your thoughtful comment, Dennis, and of course for the compliment:). What I took away from Swedroe’s argument, and other’s, was that if you look at investing through the prism of asset allocation, investing in high dividend stocks often does not make sense because they’re not a proper replacement for bonds (ie. they can’t be relied on to give you the diversification from stocks, etc., and thay have a different risk profile) nor are they necessarily going to be the best way to get “equity” returns. They’re a bit too much of a hybrid it seems. That said, there are certainly legions of people who do believe in buying stocks with good dividends, not just for the yield (though that’s nice too) but also for the reason you give too – a company that pays a good dividend is most often quite a solid business. According to S&P the Aristocrats have a one year total return ended Nov.30) of 14.33. But the 5 year annualized is a more modest 5.22. Considering that this year is in there, there must have been some pretty drab years in there to get to that average. Here’s a link to S&Ps page on the Aristocrats.: http://www.standardandpoors.com/indices/sp-500-dividend-aristocrats/en/us/?indexId=spusa-500dusdff–p-us—-

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