High-Yield Bonds Vs. Dividend Growth Stocks For Cash Flow

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 |  Includes: HYG, JNK, SDY, VGIT
by: Lawrence Weinman

Here's an examination of two alternatives for a cash flow oriented investor: a dividend growth stock portfolio vs. a high-yield bond portfolio.

The comparison is apt because both asset classes give current cash flows well above Treasury yields. For asset class comparison I make use of HYG as representative of the high yield bond asset class, and SDY, the dividend aristocrats ETF, as representative of dividend growth stocks.

Both ETFs carry an almost equal correlation to the overall stock market --.75 correlation to the S&P 500 (NYSEARCA:SPY). In terms of risk (standard deviation of daily returns, HYG is considerably less risky 12.6 vs. 20.6.

Of course, in the case of the investor interested in cash flow these risk measures are apparently irrelevant. This perspective of cash flow only, with no significance placed on total return or account value, makes this analysis all the more appropriate to investors focused on income such as the advocates of "dividend growth" investing.

Yield assumption for High Yield bonds

Based on the graph below, one can get an idea of the range for yields of High Yield Bonds over Treasury bonds. The long term average spread over Treasury bonds is a bit under 5%. The spread is currently at 6.3% and has ranged from 2.5% to 20%.

So let's use current market assumptions for our analysis. In fact we will use assumptions below those prevailing in the current market. Currently the high yield bond ETF (NYSEARCA:JNK) carries a yield of 7.5% vs, .89%% for the intermediate term Treasury bond ETF (NASDAQ:VGIT). Just to be on the conservative side, let's use a more conservative yield assumption of 6.5% for the high yield bond. That is well below the current market yield.

Now let's look at the cash flow-oriented investor indifferent to changes in principal value or real return. The investor is examining 2 alternatives: purchasing a portfolio of long term high yield bonds or a portfolio of dividend growth stocks. His goal is to meet his cashflow needs for the next 15 years.

  • The initial cash flow needs from a portfolio of $1,000,000 is $40,000
  • Cash flow need grows at an assumed constant inflation rate of 3%.

I computed the cashflows and the excess and then calculated the present value of the excess cash flows at a discount rate of 3%. In line with the mode of analysis preferred by the dividend growth analysts on SA, I have adopted the approach of making the comparison based on cash flow only, ignoring fluctuations in account balance or total return. Note that the assumptions are based on a high yield bond yield of 6.5% which is below those currently available in the market. Here are the results.

High Yield Bond Alternative Calculation of Excess By Year, Cumulative Excess and Present Value

High Yield Bond Yielding 6.5% Inflation = constant 3%

The table below shows the year by year excess cash flow, total excess cash flow and present value (PV) of the excess.

Year

Cash Flow Need

Interest Cash Flow

Excess

1

$ 40,000

$ 65,000

$ 25,000

2

$ 41,200

$ 65,000

$ 23,800

3

$ 42,436

$ 65,000

$ 22,564

4

$ 43,709

$ 65,000

$ 21,291

5

$ 45,020

$ 65,000

$ 19,980

6

$ 46,371

$ 65,000

$ 18,629

7

$ 47,762

$ 65,000

$ 17,238

8

$ 49,195

$ 65,000

$ 15,805

9

$ 50,671

$ 65,000

$ 14,329

10

$ 52,191

$ 65,000

$ 12,809

11

$ 53,757

$ 65,000

$ 11,243

12

$ 55,369

$ 65,000

$ 9,631

13

$ 57,030

$ 65,000

$ 7,970

14

$ 58,741

$ 65,000

$ 6,259

15

$ 60,504

$ 65,000

$ 4,496

$ 231,043

pv@3%

$ 186,418

Click to enlarge

For the dividend growth stock let's use the following assumptions:

Alternative 2 Dividend Growth Stock Portfolio

  • Initial Yield 4%
  • Dividend Grows at 5% Annually

Note that this cash flow scenario is dependent on the stock portfolio achieving the assumed dividend yield and growth rate throughout the life of the portfolio. Once again total return and account value are ignored. The table below shows the results of the cashflow calculation. The table shows excess by year, total excess value and present Value of the excess cash flows.

Year

Cash Flow Need

Dividend Cash Flow

Excess

1

$ 40,000

$ 40,000

$ -

2

$ 41,200

$ 42,000

$ 800

3

$ 42,436

$ 44,100

$ 1,664

4

$ 43,709

$ 46,305

$ 2,596

5

$ 45,020

$ 48,620

$ 3,600

6

$ 46,371

$ 51,051

$ 4,680

7

$ 47,762

$ 53,604

$ 5,842

8

$ 49,195

$ 56,284

$ 7,089

9

$ 50,671

$ 59,098

$ 8,427

10

$ 52,191

$ 62,053

$ 9,862

11

$ 53,757

$ 65,156

$ 11,399

12

$ 55,369

$ 68,414

$ 13,044

13

$ 57,030

$ 71,834

$ 14,804

14

$ 58,741

$ 75,426

$ 16,685

15

$ 60,504

$ 79,197

$ 18,694

$ 119,186

pv@3%

$ 63,216

Click to enlarge

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

Additional disclosure: Mr. Weinman's clients have positions in HYG and JNK