Dividend Aristocrats vs. Bonds: Not All Yields Are Created Equal

 |  Includes: GE, JNJ, LLY, MSFT, MXIM, T, VIG
by: Portfolioist

By Nanette Byrnes

A few weeks ago, Mel Lindauer expressed his worry that the super-low yields offered by bonds these days have people considering a questionable move: switching money out of bonds and into dividend-bearing stocks in a search for 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 (NYSE:GE) and Microsoft (NASDAQ: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 (NYSE: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 (NASDAQ:MXIM) offers a 5.0% yield, but the stock has traded as low as 60% off its high. Drug maker Eli Lilly (NYSE:LLY) has an even-better 5.50% yield, but it's been known to fall 50%. AT&T (NYSE: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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.