Dividend-Paying Stocks Are Not 'Bond Equivalents'

Includes: JNJ, KO, MCD, PG, T, VZ
by: The Financial Lexicon

It was not the first time I've heard the words "bond equivalent" used to describe dividend paying stocks. But hearing a very well-known and widely followed CNBC host and co-anchor use them to describe Verizon Communications (NYSE:VZ) the other day is what prompted me to write this article. In addition to being a shareholder of Verizon, if you are a shareholder of Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), McDonald's (NYSE:MCD), AT&T (NYSE:T), or The Coca-Cola Company (NYSE:KO), the message of this article is applicable to you.

Companies that (1) pay regular dividends (and even increase them on a regular basis), (2) are known for being less volatile than the S&P 500, and (3) are generally perceived to have stable cash flows have been an attractive option for investors searching for income investments in an ultra-low-interest-rate environment. The stocks of these types of companies have become known as "bond equivalents" among certain financial professionals and parts of the financial media. From what I have experienced, the stocks of each of the aforementioned companies are the ones most often referred to as "bond equivalents," but I suspect that many other stocks, such as those that are considered "Dividend Aristocrats" could also be included on the list.

What do I think of using "bond equivalents" as a way to describe certain stocks? I think it is at best illustrative of the general lack of knowledge among equity professionals regarding the world of bonds, and at worst is a sneaky way to try to encourage (and make retail investors comfortable with) rotating money out of bonds and into stocks. For a couple of years, stock market pundits have been quite vocal in regularly calling for an impending (but never arriving) rotation out of bonds and into stocks. Stocks may, from time to time, have a couple of weeks of inflows, but the often predicted mass exodus out of bonds still hasn't materialized.

Let me unequivocally state the following: Stocks are not "bond equivalents."

You may have plenty of great reasons for owning shares of any of the companies mentioned above. But if one of those reasons is because you believe they serve as "bond equivalents," you may want to revisit your investment thesis. Here are a few reasons that common shareholders of Verizon, Johnson & Johnson, Procter & Gamble, McDonald's, AT&T, or The Coca-Cola Company do not own "bond equivalents":

1. Common stock is at the bottom of the capital structure. Bonds are higher up the capital structure. If you are a common shareholder, your investment is far less protected than bondholders', and you will recover far less in the event of bankruptcy. I am sure some readers will scoff at the mention of bankruptcy in the same article that mentions companies such as Johnson & Johnson and McDonald's. Let me make it clear that I am not predicting bankruptcy for any of the companies mentioned above. But I also cannot predict what will happen to these companies in 30, 40, or 50 years. If you are a buy-and-hold investor, you need to be aware that great companies can change for the worse over time. If the now unthinkable happens, and one of those companies files for bankruptcy someday, the holders of common stock who think they own "bond equivalents" will be sorely disappointed.

2. Bonds mature at par. Stocks do not. If you own shares in one of the aforementioned dividend-paying "bond equivalents," you theoretically have unlimited upside potential to your investment. But you also run the risk of the stock declining and never recovering to the levels at which you purchased it. With a bond, however, you can rest assured that as long as the company does not default (which would, by the way, destroy the value of the common stock), the bond will mature at par. Again, some readers may scoff at the idea that any one of the aforementioned companies might decline from and never return to today's levels. I, however, would definitely not rule that out. That is a risk of owning equities, a risk that should be respected when planning for possible outcomes to your portfolio's future returns.

3. Despite the fact that certain stocks may be less volatile than the broader market does not mean you should compare them to bonds. The prices of stocks and corporate bonds have very different drivers. If you think your common stock will help smooth out returns during a bear market in the same way that corporate bonds (especially highly-rated corporate bonds) have the potential to do, I suspect you will be disappointed more often than not.

4. There is a level of predictability to bonds that there is not with stocks. Given that a bond matures at par and pays predictable streams of income, bond investors can plan with more certainty than stock investors for future cash flow needs. Dividends may go up, but they also may stagnate over time or even decline when times get tough. You may own a dividend-growth stock that was increasing the dividend at rates greater than inflation only to see the dividend increases slow to a crawl. There have been plenty of investors who purchased 3% yielding stocks in recent years, foregoing 5% or greater corporate bond yields, under the assumption that over time, the total return will outpace the bond yield. That may indeed happen. But let me make something clear: That is not guaranteed to happen.

I recognize that the potential for unlimited price appreciation and the potential for massive hikes to dividends are two reasons why stocks can be much better investments than bonds over time. Those are two of the many reasons that I own 32 individual stocks at this time, including two mentioned in this article. And each of those stocks pays a dividend. But despite owning the stocks of 32 different companies, I do not, in any way, view those stocks as "bond equivalents." They are not "bond equivalents" and likely never will be.

Disclosure: I am long T, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.