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<< Return to Part I

In Part I of this series we put dividend growth stocks and fixed income (specifically preferred shares) into the ring and let them duke it out. Instead of the “Thriller in Manila,” we’ll call it “Inflation Buster’s Last Stand.” The winner was awarded a gold belt of increasing income that beats the average rate of inflation.

The match-up looked something like this:

Mr. Fixed Income Blue Shorts has a problem with ”asset” protection. In “Inflation Buster’s Last Stand,” if he doesn’t reinvest, he will be beaten on the dividend growth front by Mr. Dividend Growth Red Shorts, who has been “working out” (growing) his dividends for years. Even with reinvestment, eventually Mr. Dividend Growth Red Shorts outstrips Mr. Fixed Income Blue Shorts on available income, as it takes more and more workout, or funds for reinvestment, for Mr. Blue Shorts to keep up.

The Visual Match-Up

The video is a funny visual reminder of the power of dividend growth investing. Many of you asked for visuals on my last article, and I am happy now to provide charts of what we learned.

In the match-up of Dividend Growth vs. Fixed Income, here is what outcome looks like visually, in terms of available income after reinvestment, when NextEra preferred shares ((FGE)) tries to match the dividend growth of NextEra Energy (NYSE:NEE) common shares:

You may be able to beat NEE for a while, but when the company throws in a 10% dividend increase for 2011, fixed income simply cannot keep up. The rate of investment required for FGE to match available income means NEE just threw a knock-out blow.

If we try to have FGE simply beat the average rate of inflation of 4%, our available income after reinvestment on FGE looks like this (see spreadsheet):

Again, NEE beats out FGE beginning in year 2010.

If we try to have FGE beat the average rate of inflation of only 3%, our available income after reinvestment on FGE looks like this (see spreadsheet):

Finally, when reinvesting for an inflation rate of 3% we are money ahead – for a while. Notice a sneaky trend is in place. The amount of available income on the fixed income side is falling slightly, while NEE continues to grow. Eventually, these will be at par, with NEE eventually surpassing FGE in terms of available income that beats inflation.

But I Need High Income Now

In the comments section of my first article, there was a bit of protest from the fixed income side, which was:

"I am retired. I need high yield current income now. Reinvesting my fixed income won’t work." If this describes you, then it truly is pointless to reinvest your fixed income. Those who need their fixed income payments now should keep them. Just keep in mind - this sense of security comes with a price.

We all love fixed income because the payout never goes down. The rub is: The payout can also never go up. With every inflationary year, you will lose more spending power. For all your money’s hard work, it’s equal to a yearly pay cut.

The Reality of Atrophy

Using our two examples again, NextEra Energy common shares, with an average dividend growth rate of 7.45%, and a NextEra preferred share, FGE with a coupon rate of 7.45%, we will map out the reality of depreciating purchase power.

We start out again with identical investments of $50,000 in 2007. While the dividend payout is much lower, with NEE at about 4%, the current dividend average growth rate is 7.45% per year. For purposes of this demonstratio,n we are assuming the 7.45% growth rate is continued through year 2017.

With (FGE), you have a set coupon rate of 7.45%, which remains constant.

A 3% decline in purchasing power due to inflation is then factored in for both investments. Keep in mind this decline is cumulative; each passing year produces further erosion of income.

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

NEE
($)

1,443

1,566

1,663

1,760

1,936

2,080

2,235

2,401

2,580

2,772

2,979

FGE
($)

3,587

3,480

3,376

3,275

3,176

3,081

2,989

2,899

2,812

2,728

2,646


The chart clearly shows that while the immediate income of FGE starts out as nearly double what would be had on a share of NEE, each passing year produces income erosion for FGE. Because NEE continues to outpace inflation in terms of dividend increase with 7.45% dividend growth, the income continues to grow, even when factoring 3% cumulative inflation. It takes only 9 years for NEE to outperform FGE in terms of available income after inflation’s pay cut is taken out.

Conclusion

In the first installment of the series, we laid out a re-investment scheme for fixed income that attempts to keep pace with inflation. We discovered that even when reinvesting up to 50% of fixed income dividends, it is still no match long-term to the inflation-busting power of dividend growth stocks which are growing dividends at a rate of 7% or more.

This second installment demonstrates that inflation has a devastating cumulative effect on fixed income dividends. While inflation also reduces the spending power of dividend growth dividends, because our dividend growth stocks are increasing payout at a higher rate of inflation, the dividend growth dividends continue to grow every year. Not so with fixed income. Each passing inflationary year strips out the purchasing power of fixed income.

Feeling depressed? Hang tight -- hope is on the way! I am planning on two more installments in this series, which will address exactly how to accomplish what so many investors need right now: high income that keeps pace with inflation.

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

Continue to Part III >>

Source: Dividend Growth Vs. Fixed Income Challenge, Part 2: The Reality Of Atrophy