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In a recent article I discussed the "nonchalant" attitude that many investors might have with regard to their income positions. While some might consider this a negative attribute, I think the carefree and confident way that dividend and bond investors approach capital fluctuation in their portfolios engenders a rational, non-emotional strategic stance. And though I'm not big on asset allocation blueprints or telling investors what specific securities they should be buying, it is critical to be invested in assets that provide the best risk-adjusted chance of meeting income goals.

While growth of income may be mission critical for many investors, I would contend, depending on individual circumstances and forward market assumptions, that bonds or higher dividend equity may be a better option than "garden variety" dividend growth if one's goal is to maximize nominal income over specifically defined time frames. Through a quantitative exercise, we will examine three widely held dividend stocks at varying yield points, speculate forward dividend growth, and discuss asset risk, with the end goal of determining when a bond may be a better idea than a stock, and when it's not.

A Bond Vs. Stock Simulation

Our goal is to maximize nominal income with little attention to total return or interim fluctuation of capital. We will assume that our bond pays out stated interest with no interruption and that each equity pays out qualified, uninterrupted dividends without reinvestment. We will measure gross income received over the life of the investment and analyze results both in and out of qualified accounts, and initially won't take into account any taxes.

I have chosen the "granddaddy" of all dividend stocks, Procter and Gamble (NYSE:PG), ConocoPhillips (NYSE:COP), and Altria (NYSE:MO) upon which to conduct a comparative examination of forward outcomes over different time frames and dividend growth rate assumptions. We will compare these equities to BBB rated paper (low end of investment grade) from S&P, with a somewhat blended take on yield currently available in the market. We will invest $10,000 in each equity and

Based on historical performance and a somewhat speculative view on their respective businesses, I am going to apply a 6% dividend growth rate to PG, a 5% rate to COP, and a 8% rate to Altria. For the BBB bond, we will assume the interest rate as stated in the chart. The following chart tracks our gross nominal cash flow after each period.

Stock (DG %)Near-Term YieldCash after 5 Years-Bond 4.25%10 Years-Bond 5.25%15 Years-Bond 5.75%20 Years- Bond 6.35%25 Years-bond 7%
PG (6%)2.9$1634$3820$6745$10660$15901
COP (5%)3.8$2100$4778$8179$12541$18110
MO (8%)5.1$2992$7387$13845$23335$37279
BBB BondVariable$2125$5250$8625$12700$17500

Analysis

The results are certainly interesting. Our lower dividend, lower growth equities, (PG & COP) significantly lag Altria, while basically only keeping up with the bond. And even though we applied a lower annual dividend growth rate to Conoco, the fact that we started with a nearly 100 basis point yield advantage over PG provided much more gross income, even after 25 years. Thus we could conclude from the data that it may be advantageous to find higher dividend payers with mildly lower dividend growth rates than the opposite if our goal is nominal income.

The Impact of Taxes

Our simulation did not take into account the spread between ordinary tax rates - the rate at which bond interest is taxed, and the qualified nature of dividends from most corporations. As we can see in the tax chart below, the spread between ordinary and qualified rates rests somewhere between 10 and 20 percent, depending on ordinary tax rate.

Dividend Taxation in the United States
2003-20072008-20122013 +
Ordinary Income Tax RateOrdinary Dividend
Tax Rate
Qualified Dividend
Tax Rate
Ordinary Dividend
Tax Rate
Qualified Dividend
Tax Rate
Ordinary Dividend
Tax Rate
Qualified Dividend
Tax Rate
10%10%5%10%0%10%0%
15%15%5%15%0%15%0%
25%25%15%25%15%25%15%
28%28%15%28%15%28%15%
33%33%15%33%15%33%15%
35%35%15%35%15%35%15%
39.6%N/AN/AN/AN/A39.6%20%

In the next chart we will apply a 13% reduction to our bond interest and run the simulation again, given the 28%-15% spread that an average American taxpayer in the 28% bracket would experience when preparing their taxes.

Stock (Dividend Growth %)Near-Term YieldCash after 5 Years-Bond 4.25%10 Years-Bond 5.25%15 Years-Bond 5.75%20 Years- Bond 6.35%25 Years-bond 7%
PG (6%)2.9$1634$3820$6745$10660$15901
COP (5%)3.8$2100$4778$8179$12541$18110
MO (8%)5.1$2992$7387$13845$23335$37279
BBB Bond (minus 13%)Variable$1849$4568$7503$11049

$15225

With a tax adjustment figured into our bond interest, the COP position starts to look much more attractive, while PG now poses a relative wash with our bond. If you are a taxpayer in a higher bracket, the tax implication becomes increasingly more significant as your ordinary income increases. If you are in the top tax bracket, your bond interest will cost you nearly 20% more in taxes compared to qualified dividends received.

The Inflation Question

Many income investors point to the inflation fighting aspect of dividend growth stocks as rationale for opting for equities as opposed to fixed income. I believe this simulation proves that even though most bonds may not possess the step up feature available to dividend growth stocks, a carefully purchased investment grade bond can keep up with the income capabilities of dividend equity possessing average characteristics (3-4% yield, 5-8% growth).

Factoring in Risk

While risk is a very subjective matter when it comes to income investing, I continue to feel that a bond, given the contractual capital return guarantee and its durable income component, poses a lower overall risk proposition relative to "low beta" equity. In a recent article, SA cohort David Van Knapp took the position that low beta equity could be viewed as a substitute for bonds by dividend investors.

If we factor in some assumptions with regard to a lower volatility dividend equity, like a PG, Colgate-Palmolive (NYSE:CL), Coco-Cola (NYSE:KO), et. al., namely that the company does not run into financial difficulties, causing it to freeze, lower, or totally drop its dividend, then I think Dave's thesis holds merit. However, there is no guarantee that that will be the case. Further, if a company were to run into financial difficulty, bondholders sit higher in the capital stack than equity holders, which means in a worst case scenario, bondholders would make out better.

Further, our simulation above included assumptions related to BBB rated paper. If an investor were willing to up the credit ante and delve into the higher end of non-investment grade fixed income (BB or BB+), the relative attractiveness of the income would improve. With the economy holding up and defaults in high-yield land of just about 3% currently, there is obviously risk, but not a ridiculous amount in my view.

Other Dividend Stock Considerations

While bonds seemed to hold their own against two of our three dividend growth stocks, they were blown away by our assumptions made with regard to Altria. As I posited above, it appears that a large starting yield may more than compensate for a slightly lower growth rate, even over longer periods. However, with Altria, we assumed the best of both worlds, a high starting yield and a higher long-term growth rate. These are the companies that income investors want to find.

But as the market continues to expand and yields continue to contract, my view is that it is becoming much more difficult to find value in the market, whether measured by strict earnings methodology, overall business strength, or forward dividend growth potential. Though capital tends to be a subservient consideration for income investors, I would say near-term valuation expansion should be more than a fleeting concern for dividend equity investors and could certainly pose rationale in a decision to opt for fixed income.

Another consideration for equity investors would be to choose shares of equities with elevated yields but limited or non existent dividend growth rates. Companies of this nature would include REITs, utilities, many MLPs, and business development companies. I would actually contend that these companies might make the better bond proxy or substitute in today's market, given their attributes of steady cash flows but limited, inconsistent, or negative dividend growth potential. I still advocate judicious and limited exposure to equity REITs, and particularly like American Realty (NASDAQ:ARCP) as well as NorthStar Realty (NYSE:NRF).

I continue to think that mREITs are a speculative gamble, and despite their double digit yields, advise that conservative income investors avoid them.

Conclusion

It's been pretty much been drilled into income investors' heads that bonds are in a bubble, are terrible investments, and should pretty much be avoided. From a total return perspective, I would agree that bonds don't look terribly attractive, However I would contend that if one's goal is simply to accumulate cash, bonds hold up pretty well and may offer a better risk-adjusted play in many circumstances, if held to maturity.

Source: When Bonds Are Better Than Dividend Stocks (And Vice Versa)

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.