I recently came across an article by Tim McAleenan that posed rationale as to why bonds should not be part of an investment portfolio. As someone who has been investing in bonds for almost two decades, I didn't totally identify with the argument, although from a tactical, comparative viewpoint, I understand Tim's sentiment.
While I would have preferred if he had utilized yields on BBB-rated investment grade paper instead of Treasuries when making his yield comparison argument - as one can get double the yield in BBB - I do agree with him that it is prudent for investors to be carefully scrutinizing the decision to invest in bonds versus dividend equity in the current market. For some a 0% allocation to bonds and 100% to dividend growth stocks might indeed be the right investment solution, although I could probably just as easily argue that for others a 100% bond allocation might be more apropos.
But taking a step back from the obvious differences in the fundamentals of dividend growth stocks and bonds and who might be investing in them, there is a notable nonchalance in the way that both groups of investors view the price volatility of their holdings. Though nonchalance towards price might be considered a negative investment attribute by some, I think it is a positive quality for those that might be prone to making emotional decisions.
On the one hand, dividend growth investors tend to be nonchalant towards stock price so long as the business remains healthy and the income stream keeps growing. Passive bond investors also can also be nonchalant to interim bond pricing and interest rate fluctuations, knowing that their capital will be returned in full upon maturity in addition to the interest culled over time.
Cases For 100% Bond Allocation
Stocks can be volatile. We all know that. And there are some people that just can't stomach the potential for capital loss, even if just on paper. Though you can coach someone, and sing kumbaya to them to help them through rough times, there are those that will inevitably panic, selling when the market turns - even if their income is not at risk. These people should not be in stocks, they should be in bonds and cash.
Further, while we have always been taught to think that the market always bounces back from adversity - and historically it has - there is certainly no guarantee of that in the future. Take Japanese stocks for example. Those that invested in the Nikkei back in the late 80s are still waiting to get their capital back. Those that invested in the Nasdaq in the late 90s are also still under water. Bonds have capital guarantees that stocks don't.
Nikkei 225 ~ 30 years
So for the pessimistic or panic-prone stock investor who does not have the discipline to ride the stock market's wave or blind themselves to inevitable capital fluctuation through a strategy such as dividend growth, bonds are a prudent choice. While I think now is not the most opportune of times to be buying long-term bonds, there is certainly wisdom in the capital protection aspect of bonds if one is melancholy or downright scared about equity market prospects. While many dividend growth adherents might see "low beta" dividend stocks as a substitute for the income predictability of bonds - a view I would tend not to argue - the lack of a guaranteed capital return would make even low beta equity an arguably reckless choice for someone predisposed to preservation. Outside of cash, the best capital preservative on the planet is a carefully chosen bond.
Thus I would posit that a 100% bond allocation may be appropriate for some, particularly those with weak stomachs, a specific need to preserve capital, a bearish view on equities, or a belief that rates will remain indefinitely low. My personal feel is that most income investors would benefit from a variable combination of both asset classes, but everyone's capital situation, risk tolerance, and forward market view is different, so I would certainly not be a wholesale pusher of either asset.
The Stock Or The Bond? - Two Case Studies
With low fixed income interest rates and competitive yields found in dividend equity, it is rational that traditional bond investors are being wooed over to stocks. I thought it might be interesting to look at two dividend stocks, compare their equity yields and 10 year bond interest rates and go through the thought process of the average investor focused on maximizing income. The companies that we will be looking at are diversified food purveyor, Conagra Foods (NYSE:CAG) and Darden Restaurants (NYSE:DRI), the operator of the Olive Garden and several other casual dining concepts. Both companies are rated BBB- (bottom end of investment grade) by Standard & Poors.
Taking up Darden first, here's a dividend growth investor favorite that has hit a bit of an operational roadblock over the near-term, but offers a juicy yield of 4.2%. The company has tripled its dividend over the past five years, but may not be in a position to aggressively raise it any further. Speculatively speaking, we may be looking at mid single digit dividend increases or even worse until it sees an earnings renaissance.
On the credit side, after doing a search I was able to find a Darden bond maturing in October of 2021, about 8 years out, yielding right around 5 percent. So does an income investor opt for the additional 20% yield afforded by the bond or opt for the equity with hopes that yield on cost will rise in the years ahead? Assuming 5% annual dividend growth over the next eight years, the initial 4.2% yield at today's price would rise to yield on cost of about 5.6 percent. However, one can certainly posit more optimistic or pessimistic scenarios.
Thus, the question of whether to buy Darden's stock or its 2021 bond in a pure attempt to optimize income over the 8 years would be dependent on feel regarding the company's future dividend growth, time frame of investment, and capital preservation needs, amongst other variables. In the case of Darden, my sense is that the income investor comes out ahead by investing in the equity over the course of the 8 years, but given the near-term operational clouds and elevated payout ratio, the road may be volatile and may not be appropriate for those with a weak stomach (pardon the pun).
On to Conagra, this is another food related company that has run into some issues over the near-term. Conagra's equity yields about 3.1% but has been a much slower dividend grower compared to Darden, having raised its distribution to investors only 40% over the past seven years - although its payout ratio is currently lower than Darden's.
Looking at its credit side, I was able to find a Conagra piece of paper maturing in about 9 years (Jan. '23) yielding only about 4%. If we take the view, again, that CAG will grow its dividend about 5% a year until the bond matures, we end up with about 4.36% YOC.
My sense on CAG is that the company will be able to do a bit better than 5% for investors going forward, so YOC may be a bit better. In any case, given the 5% that we are able to get on a Darden bond with a shorter maturity and similar credit picture, I'd be in no rush to buy the Conagra bond and would certainly opt for the Darden bond.
As far as the equity is concerned, from a forward yield on cost perspective, Darden would seem to provide for the better opportunity, even if we factor in a bit better dividend growth rate for Conagra. However, I feel Conagra is more attractively priced and provides for the better total return opportunity going forward.
Though dividend growth and bond investors may have different outlooks and strategic rationale for their investment choices, both can succeed while maintaining a rather carefree attitude towards capital fluctuation. While I'm generally of the feel that no one should hold 100% of a portfolio in any one type of asset, there are times, strategically speaking, when such a game plan may make sense. The bottom line in today's difficult ZIRP environment is whether opting for stocks or bonds, that income investors employ prudent, unemotional strategies that enable maximum current and future cash flows while minimizing overriding risks.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.