2023-11-25 05:22:32 ET
Summary
- With bond yields at levels last seen before the Great Recession, it is difficult to argue against the attractiveness of fixed-income investments.
- However, it is extremely important to focus on the long term and consider three aspects before chasing the current high bond yields.
- The article discusses aspects such as minimizing reinvestment risk, inflation hedging, and currency diversification.
- Unlike bonds, certain equity securities inherently offer these benefits.
- In addition to discussing these three aspects, two caveats are mentioned that are particularly relevant for risk-averse investors.
Introduction
I don't think I'll ever forget the 2020 narrative, that the zero-interest rate environment (even negative interest rates in some countries) is here to stay. As is so often the case, things turned out very differently. Interest rates rose at an unprecedented pace and long-term interest rates are now at levels last seen before the Great Recession.
Against this backdrop, it seems difficult to make a case for dividend stocks, especially when their dividend yield is well below the current yield on long-term bonds. Take The Procter & Gamble Company ( PG ), for example. The company currently pays a quarterly dividend of $0.9407 per share, which equates to a yield of 2.49%. That's 43% less than the current yield of 4.41% on the 10-year Treasury bond, or nearly half the current yield of 4.81% yield on P&G's 2007 notes , which mature in 2037.
Of course, the comparison is not entirely fair, considering that a consumer goods company like P&G with a rock-solid balance sheet ( Aa3 credit rating ) can likely continue to grow its dividend at a healthy pace and there is the potential for capital gains. However, even taking into account the 5-year compound annual dividend growth rate of 5.6%, an investor in P&G would still have less pre-tax income after ten years - 27% less to be exact ($3,217 vs $4,407):
Looking at these figures, it seems foolish to invest in dividend stocks if income generation is the only thing in mind, doesn't it?
At first glance, it's hard to argue against bonds from an income generation perspective - after all, they are also less risky (if you agree with the academics that risk equals volatility). However, there is more to consider.
Let's look at the three main reasons why I haven't moved away from dividend stocks in 2023, even though the starting yields on my investments are usually well below the current yield on long-term bonds.
Reason 1: The Reinvestment Risk
Reinvestment risk can be seen as the opposite of duration risk.
In short, duration is the weighted average time until repayment - it is an indicator of the interest rate sensitivity of an investment. Zero-coupon bonds are the easiest to understand, as they contain no coupon payments and are issued below par, but are redeemed at par at maturity. Their duration is equal to their maturity. The duration of regular bonds is lower than their maturity. It follows that a bond with regular coupon payments is less risky than a zero-coupon bond with the same term. I have discussed the duration aspect of bonds (and equities) in more detail in another article , pointing out that the duration of growth stocks is much longer than that of value stocks (i.e. stocks with significant short-term cash flows) and investors should be mindful of this aspect in a low interest rate environment.
In my view, a portfolio must be designed to meet the cash flow needs of the investor. Therefore, bonds can make a lot of sense due to their contractual maturities and consequently reliable cash flows. In contrast, equities have no maturity and there is no contractual repayment guarantee.
However, an investor who wants to preserve his capital and expects to live off the distributions from his investments must consider the reinvestment risk. A newly issued 10-year government bond entitles the investor to fixed-rate, semi-annual coupon payments over the next ten years. A current yield to maturity of 4.41% sounds tempting, but what happens after ten years? The investor has to reinvest his capital - possibly at lower interest rates than today.
Let's look at the example of investing $10,000 in 10-year Treasury bonds versus investing in Johnson & Johnson ( JNJ ) stock (see my latest article on the pharma/medical devices giant). JNJ is a high quality company with an Aaa credit rating, very reliable cash flows and a well-diversified portfolio. It is a dividend king with a 61-year track record , a five-year compound annual dividend growth rate of 5.75% and a current dividend yield of 3.15%.
While the bond yields higher cash flows in the first few years, JNJ's yield-on-cost overtakes it after seven years. Worse still, if long-term interest rates are close to 1% in 2034 in another hypothetical economic crisis, a bond investor must plan for comparatively poor cash flows for the following period due to the necessary reinvestment of his capital (Figure 2).
So over the next twenty years, assuming JNJ can maintain its track record (I've factored in a 20 basis point annual decline in the annual dividend growth rate), the investor in JNJ will generate pre-tax dividend cash flows totaling nearly $10,000, while an investment in 10-year Treasury bonds would only generate $6,000 over the same period.
Of course, one can argue that interest rates will indeed stay higher for longer, suggesting that reinvesting at a 1.1% rate is an unrealistically pessimistic expectation. However, I think it is worth posing the question of how likely it is that the Federal Reserve will be able to keep interest rates at current levels for years and possibly decades, given that government debt is at an all-time high and interest coverage is getting worse (Figure 3). It is also important to remember that the current interest rate environment is only gradually working its way through the economy. While current charge-off rates are not yet worrisome and the rate is increasing only slowly (Figure 4), it will eventually reach dangerous levels if the Federal Reserve does not change course.
In addition to the reinvestment risk at maturity, it is worth noting that certain corporate bonds are equipped with an issuer call option. In a low interest rate environment, issuers have an incentive to call bonds with a higher than current effective yield, forcing bond owners to reinvest their capital at a comparatively unattractive interest rate. Although the market usually prices the call option into the bond price, it is still important to look closely at the bond prospectus.
Overall, I feel much more comfortable owning shares in high-quality companies that pay a steadily growing dividend than owning a long-term bond that currently has a tempting yield but a pronounced reinvestment risk. Of course, reinvestment risk can also be reduced by longer-term bonds such as 20- or 30-year Treasuries or the infamous 100-year Austrian bond (conversely, note the pronounced interest rate sensitivity), but there's more to consider...
Reason 2: Growing Dividends Are The Only Real Hedge Against Inflation
It is a common misconception that a bond with a yield equal to or higher than the current inflation rate offers sufficient protection against the erosion of purchasing power of one's income .
However, it is correct that the purchasing power of the invested capital is preserved. For example, an investment in a bond with a yield of 3% retains its purchasing power as long as the annual inflation rate is exactly 3%.
Put differently, the coupons received in year one have only lost about 2.9% of their purchasing power, while the final cash flow in year ten has declined more than 25% in terms of its purchasing power. Of course, this also applies to the capital that is repaid after ten years. The $3,000 in income generated with the bond over ten years has a purchasing power of $2,559, while the repaid principal has a purchasing power of $7,441 - or $10,000 in total (Figure 5).
The key takeaway is that there is no real income generated after inflation. And keep in mind, the example doesn't factor taxes into the equation. So after taxes - it's also worth noting that bond coupon payments are oftentimes taxed less favorably than qualified dividend payments - the bond investor loses purchasing power even if the inflation rate is at or slightly below the coupon rate.
In stark contrast, however, even an investment in a very low-yielding stock such as Visa Inc. ( V ) handsomely beats also the recently elevated rate of inflation from an income perspective. Of course, the capital is "gone", so to speak, as there is no contractual repayment. However, investors who expect to fund their living expenses with the cash flows of their investments are not really looking for repayment (see above - reinvestment risk). With the inevitable (but rare) exception, they invest in stocks of companies that they intend to hold for the long term. Even though they buy their shares on the secondary market, they are nonetheless de facto entrusting their capital to the management, which has a fiduciary duty to fulfill.
Visa stock currently offers a yield of 0.82%, but the payout to shareholders has grown at a compound annual growth rate of 15.8% over the past five years. I'll admit that this is a bit of an extreme case - at some point, dividend growth will slow - but it nicely illustrates how the purchasing power of Visa's dividend grows over time. If the company can maintain its current growth rate over the next ten years - which is not unrealistic given its projected double-digit earnings growth rate, high cash flow profitability and payout ratio of around 20% (Figure 6) - the purchasing power of the dividend would double after eight years, despite an expected rate of inflation of 4% p.a. in this example. While the bond investor still earns the higher income in actual dollar amounts after ten years, the purchasing power of his contractual cash flows has declined year after year.
Figure 7 compares the purchasing power of the Visa dividend (blue bars) with that of a 4.41% bond coupon (red bars) after accounting for 4% inflation. Figure 8 shows the evolution of purchasing power in relative terms.
The figures also show how the purchasing power of dividends from PepsiCo, Inc. ( PEP ) - the leading snacks and beverages company - and major tobacco company Altria Group, Inc. ( MO ) can be expected to evolve. I covered PEP stock and MO stock only recently, and both are important additional examples: PepsiCo because it still trades at a reasonable dividend yield of 2.99% (9% higher than the five-year average ) and has increased its dividend at a fairly healthy rate of 6.4% (five-year CAGR). As the gray bars in Figure 7 show, an investment in PEP still yields competitive short-term cash flow, and its purchasing power-adjusted value exceeds that of the bond coupon after eight years.
The purchasing power of Altria's dividend will likely remain stable for the foreseeable future but should not be expected to increase significantly. While it may seem obvious to characterize Altria stock as a "bond proxy" with inflation protection on its payouts, it's important to remember that dividend payments are discretionary and Altria's room for earnings growth is increasingly limited, as I explained in this article . I don't see a dividend cut on the horizon, but at the same time, it's hard to ignore Altria management's missteps and the company's weak position in smoke-free products.
In summary, investing in fixed-interest bonds with the intention of living off the income generated can be a dangerous undertaking. In times of persistently high inflation, bond coupons quickly lose purchasing power. By investing in companies with staying power, an economic moat, ideally with low capital intensity and high pricing power, it is very likely that the purchasing power of the dividend income will not only be maintained over time, but often even increased. To use a real-world analogy, comparing the coupon rate or dividend yield of a stock to the prevailing inflation rate would be like comparing the top speed of one car to the acceleration of another.
Reason 3: Currency Diversification And Hedging Potential
It is often advised to invest in bonds denominated in the investor's home currency in order to avoid exposure to currency risk. Of course, this makes a lot of sense - imagine you are based in the U.S. and only invested in 30-year gilts (U.K. government bonds) in 2004:
But should a U.S. investor really only buy U.S. bonds and a U.K. investor limit their investment horizon to the comparatively small universe? That's a very personal decision, but I think it's fair to say that geographic diversification makes sense, and I think dividend stocks can be useful in that regard.
British American Tobacco plc ( BTI , OTCPK:BTAFF ) reports its profits in sterling and is domiciled in the U.K. The fact that the company declares and pays its dividend in sterling is, of course, useful and appropriate for a U.K.-based investor. To satisfy the desire for currency diversification, the investor should perhaps - from a superficial point of view - look for a company that reports its profits in dollars or euros.
However, knowing that BAT generated 43% of its 2022 net sales in the U.S., it is easy to understand that the tobacco company's earnings benefited from the strong dollar in 2022. As shareholders, we are entitled to a share of the profits - a large part of which BAT distributes in the form of dividends. Profit growth, which is in this case partly due to the appreciation of a foreign currency, supports dividend growth. All else being equal, a U.K. investor - who may be concerned that their purchasing power will fall as imported goods become more expensive due to sterling's weakness - should therefore consider the dividend cash flows of a company with significant overseas operations as a hedge. However, because of the relatively high percentage of dollar-denominated debt on BAT's balance sheet, a more conservative example in this context would be U.K.-based conglomerate Halma plc ( OTCPK:HLMAF , OTCPK:HALMY ), which I also covered here on Seeking Alpha .
Similarly, a U.S.-based investor seeking indirect foreign exposure but still preferring to be paid in dollars might want to take a look at stocks of domestic companies with significant international exposure. PepsiCo, Johnson & Johnson and Procter & Gamble - but of course not Altria (100% U.S. sales) - fit the bill particularly well.
However, as a note of caution, it is important to look closely at the company's actual geographic exposure. Take Philip Morris International, Inc. ( PM ): although the company reports its earnings and pays its dividends in U.S. dollars, it did not have operations in the U.S. prior to the acquisition of Swedish Match in 2022 ( see this article ). Those who bought PM stocks before the transaction were tacitly assuming currency risk - after all, a rising U.S. dollar meant weaker profits for PMI and hence less room for dividend growth. Of course, one can argue that the company is hedging its currency risk, but currency hedges come at some cost and the FX-impact can nonetheless be significant. This becomes clear when looking at Philip Morris' earnings reports. However, over time and with PMI's re-entry into the U.S. market also via its IQOS and IQOS ILUMA heated tobacco franchises, the company should be viewed more and more as a globally diversified business.
I personally maintain a globally diversified portfolio of dividend stocks. Despite the fact that I am based in the E.U. and pay my living expenses in euros, I am "overexposed" to U.S. stocks and even own stocks from Switzerland that pay their dividends in Swiss francs. And although I may have a concentration risk in percentage terms, I keep an eye on the actual, company-specific geographic exposure to maintain a diversified portfolio.
A Few Caveats To Keep In Mind
Of course, this article could come across as the ultimate argument for dividend stocks and against bonds. However, I would like to emphasize that bonds can have a place in a portfolio and that there are some caveats before going "all-in" on dividend stocks as an income investor.
First and foremost, it should be emphasized that dividends are declared and paid at the discretion of the company's board of directors and management. Without growing earnings and cash flows, there is no basis for sustainably increasing dividends, but it also requires shareholder-friendly boards and executives. It is therefore extremely important to examine not only a company's business model, profitability and balance sheet, but also its dividend policy and management. And it is equally important to examine corporate earnings in relation to economic cycles. It makes no sense to invest only in high-yielding commodity or industrial stocks and run the risk of dividend cuts in the next downturn.
Almost as important as the realization that dividend payments are discretionary is the volatility of stocks. While bonds can and do fluctuate in price, as long as traditional bonds are held to maturity, they are repaid at par (assuming the company has not defaulted on its debt). In contrast, stocks can be very volatile and price fluctuations of 20% or more are not uncommon. Investors need to be able to stomach this kind of volatility, and this can be particularly difficult when the portfolio has reached a value in the millions. Imagine "losing" a few hundred thousand dollars in a matter of weeks, as happened in early 2020 - could you stomach that? A certain proportion of long-term government bonds therefore can be quite helpful in this context - also because in a downturn, when interest rates are typically lowered, bond prices rise accordingly (provided they do not have a pronounced credit risk).
In my view, the percentage of bonds in a portfolio should adjust with age, but this is of course a very personal decision. In my own portfolio, I don't currently own any long-term bonds, but I can imagine shifting an increasing percentage of my portfolio volume into bonds as I get older. It's only reasonable to expect risk tolerance (psychology) to decrease with age, even if risk capacity (financial aspects) might actually improve.
Key Takeaways
Despite the currently tempting yields on long-term government bonds and high-quality corporate bonds (the yield spread on junk bond remains surprisingly small), I have not turned away from high-quality dividend stocks in my long-term investment portfolio. There are three main reasons for this decision.
Firstly, there is no real reinvestment risk with equities as there is no contractual right of repayment. If I buy a ten-year bond today, it certainly sounds good from a yield perspective (especially compared to blue-chip stocks with lower yields), but I would hate to be forced to reinvest my capital at redemption in another low or zero interest rate environment. With a long-term investment horizon, I don't think there is anything better than stocks of highly-profitable dividend paying companies with staying power, a strong economic moat, and of course pricing power.
Secondly, it is a common misconception that a bond with a yield to maturity equal to or above the prevailing inflation rate provides adequate protection against the erosion of purchasing power of one's income. Granted, a bond with a coupon equal to the rate of inflation preserves the purchasing power of capital but does not generate any real income. In contrast, equities are the only productive asset that can actually protect against inflation. While a dividend growth rate equal to the inflation rate preserves the purchasing power of dividend income, investors in companies that have historically increased their dividends ahead of inflation, have actually seen their purchasing power increase.
Finally, stocks of globally diversified companies can have a beneficial diversification effect from a currency perspective. The geographical diversification of a company can have a significant impact on its earnings and therefore on the valuation of its stock and its ability to grow the dividend. For example, and of course that's greatly simplified, dividends from a domestic company with predominantly international exposure can be seen as a hedge in the event that the local currency gradually depreciates and imports become more expensive as a result.
With all these arguments in favor of shares in dividend-paying blue-chip companies, however, it should not be forgotten that dividends - unlike coupon payments - are completely discretionary. There is no contractual right to the payment and if a company defaults, equity investors are at a disadvantage compared to bond investors. It is therefore crucial to know and understand one's companies, their fundamentals and their management teams well. It is also important to keep in mind how notoriously volatile equities can be. The older an income investor gets and the larger their portfolio becomes, the more important it is to know exactly what their risk tolerance is. This aspect of successful investing cannot be overemphasized.
Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there's anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.
For further details see:
3 Reasons You Should Stay The Course With Dividend Stocks