Corporate Bonds vs. Dividend Stocks: Which Is Better for Income Investors?

 |  Includes: ABT, COP, GIS, MDLZ, MO, PEP, PG, PM, T, VZ
by: Parsimony Investment Research
As the Federal Reserve maintains its “exceptionally low” interest rate policy, conservative income investors searching for yield have been driven to the investment grade corporate bond market. Given the low nominal yields provided by corporate bonds, and the maturity timeline required, equities of these same investment grade corporate issuers offer patient, long-term investors a great alternative. While nominal rates on Treasuries and corporate bonds have plunged since the start of the recession, dividends of high quality large capitalization equities have actually increased.
The table below outlines selected bonds from investment grade corporate issuers. You'll notice that the current yield-to-maturities on the these bonds are much lower than the actual coupon. This is because the bonds are currently trading at a premium (above par). As demand has remained strong for these safe income-generating assets, prices have increased and yields have decreased. Bond yields move inversely to bond prices. The average yield-to-maturity for the bonds below is 3.52%, despite having an average coupon of 6.42%. Bond coupons are somewhat misleading these days and investors should be aware of this.
We think investors should look at the equity securities of these same investment grade corporate issues, which provide very attractive dividend yields with a similar risk profile. In addition, equities will hold up much better in an inflationary environment, when corporate bonds tend to do very poorly.
As you can see from the table below the average dividend yield of these same corporate borrowers is 4.03%.

These companies have very strong balance sheets and stable earnings and should hold up just as well as the bonds in an economic downturn. Another benefit of owning the equity is that investors can protect/augment their dividend income utilizing a covered call strategy.

Disclosure: I am long MO, ABT.