Relative Value: Stocks vs. Bonds

Includes: BWX, DTN, DVY, LQD, SPY, TLT
by: Surly Trader

Income is a crucial aspect of all investment strategies. In my previous post, “Income from Equities or Bonds“, I made an unbiased argument that the dividend yield from stocks looked better than the income from most fixed income investments. That view remains true, even though the yield on 10 year bonds has increased by 20 bps since that article on March 6th.

By looking at the dividend yields of large cap stocks drawn from the S&P 500 versus the 10 year Treasury yield, we can see that some stocks still look like a good value versus fixed income.

The top dividend paying stocks yield nearly 1.75% higher than the 10 year Treasury.

In addition to paying a higher yield than the 10 year Treasury, the highest dividend paying stocks have low Price to Forward Earnings ratios. You will probably take more volatility in your portfolio by investing in high dividend paying stocks, but remember that you are entitled to a growing stream of all future income from that company. When you buy a fixed 10 year Treasury bond, you lock in that fixed rate for 10 years.

This disparity between dividend yields and Treasury rates has two big drivers:

  1. The Fed has kept short-term interest rates low with little realized inflation.
  2. Large companies cut costs quickly during the recession and are now straddled with cash.

I would much rather have companies pay out a large dividend to me as a shareholder rather than “invest” that cash in takeovers/mergers or other poor investment schemes.

This is not a call that equities are undervalued, just that equity investments in cash rich companies with strong dividends seem like much better investments than fixed rate investments in a debt-burdened government.

You probably want to stay away from dividend yields that look too good to be true

Disclosure: Author holds long positions in T, LLY, MO