Your investments: Using stocks in place of bonds

As global financial markets continue their volatile way, many investors have thrown in the towel regarding investing in stocks and have moved all their money into bonds. As investors stay glued to every news report that may shed light on the potential collapse of the Euro, as well as a slew of new data showing a slowing US economy, preservation of capital has taken on added importance.

According to ICI data, over $150 billion has flowed into bond funds so far this year. This continues a trend of huge inflows since 2009.

History

Traditionally yields on bonds outpaced the dividend yield on common stock.

This is a reason that investors would incorporate bonds into their portfolio.

They could get a fixed yield and a reasonable level of safety. In fact, according to data from the widely acclaimed Yale economist Robert Shiller, since 1962, top quality bonds in the US have carried an average yield of 8 percent, while stocks have yielded an average of 3%.

Not so in 2012.

Today if someone promises you a guaranteed 8% yield you can be sure that there is something very fishy going on.

Due to this huge influx of cash being used to buy bonds, bond prices have skyrocketed, meaning that yields on traditional income-producing investments like investment-grade bonds and deposits are paying next to nothing (inverse relationship between bond prices and yields).

It has gotten to the point that in many cases, a company’s stock dividend is much higher than the bond yield of the same issue. It’s this search for yield that has created an interesting situation.

Investors can now generate more income from stock than they can get in a bond of the same company.

Higher income

According to Jack Hough of SmartMoney magazine, “Investors who buy Procter & Gamble [PG] bonds that come due in 15 years get a yield to maturity of about 3% a year. Those who buy the company’s stock, meanwhile, get a dividend yield of 3.7%.”

Hough continues, “P&G raised its dividend payment by 7% in April, marking 56 straight years of increases. If a company increases its dividend by 7% a year, payments to its shareholders will more than double by year 12, while those to its bondholders will be unchanged. But over a long enough time period, dependable dividends can offset much of that uncertainty.

If P&G can grow its dividend payments by just 5% a year, then after 13 years, stockholders will have collected more than $66 in dividends for each $61 share they bought today.”

This means that not only do you generate the income, but you have potential capital appreciation as well. Other well known companies like Chevron, Coca Cola and Johnson and Johnson have similar metrics. It’s important to keep in mind that as opposed to bonds, stocks can lose some of or all of their value and companies can cut their dividends. Just because PG has increased its dividend for 56 consecutive years, doesn’t mean that if their business begins to suffer – that they won’t cut or eliminate their dividend altogether.

Not for everyone

In this interest-rate environment, one should take a long look at dividend paying stocks as a way to help lower market volatility and generate income. It’s important to emphasize that fixed-income investors who try to enhance the income generated in their portfolio solely through investing in dividend-paying stocks are doing so at their own peril.

The chance that the stock bought drops substantially surely exists. Stock market investing is risky, and as such, someone living on tight fixed income should stick to low yielding bonds instead of putting principal at risk. But for investors who have some wiggle room regarding the income they need to generate in order to meet their lifestyle, or are looking for an alternative to a highly-volatile portfolio, dividend paying stocks in this current environment are worth investigating.

aaron@lighthousecapital.co.il
Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.