Are Dividend Stocks A Substitute For Bonds?

by: Lawrence Weinman

Dividend growth zealots and maniacs seem to think they have discovered a substitute for bonds in a long-term portfolio. There's one guru making the recommendation that a long-term investment portfolio replace bonds with dividend growth stocks.

In fact the same guru has coined a new term in finance or at least a new definition of the term: disintermediation. I'm not sure what it means to him. For the rest of the world of finance it means when investors or lenders provide capital directly rather than through a financial intermediary: a bank or capital market. Check here. Last I checked, dividend stock investors invest through the capital markets.

One last note on what I view as recency and confirmation bias among the dividend zealots and maniacs.

Yesterday's Treasury bond auction produced record low interest rates on 10-year maturities.

Here is a long-term chart of 10 year Treasury yields. As a consequence of the move shown here we are at one of the few times in history when the S&P 500 yield is above that of 10-year Treasuries.

A good part of what is driving all the interest in high dividend stocks is that dividend yields are higher than Treasury Bonds, the difference is far lower when compared to investment grade bonds.

One dividend zealot has posted an article with a "matrix" comparing stocks to bond yields. I'll put aside that she ignored the far higher possibility that the principal value of the stocks could fall and are certainly far more valuable than stocks. That's to be expected, zealots don't pay attention to total return.

So instead of a matrix I'll run a couple numbers, and I will make the simplifying assumption the stock price doesn't move.

A 5% dividend payer with the dividend growing at 5% reaches a 7% dividend after 7 years an 8% yield after 9 years. Zealots and maniacs may think dividend growth stock is always superior to a 10-year bond at a yield of 7% or 8%, and in fact would argue that due to "disintermediation," investors should reduce or eliminate their bond holdings and move the money to dividend stocks. As for other investors… I'm not so sure they would reach the same conclusion.

They might run the following comparison:

$1000 invested in a 7.5% zero-coupon bond end value after 10 years grows to $2061. Of course if it is a Treasury or investment grade corporate bond, that return is considered extremely low-risk for loss of principal, and the zero-coupon investment has no reinvestment risk. In other words, the likelihood that the balance at the end of the investment period is lower than the initial investment is far higher for the stock investor than the bond investor. I know dividends and zealots care nothing about end value. If they pull out the dividends through retirement and the principal declines from that point on - after all it no long has the benefit of dividend reinvestment. Of course some people care about how much is left in the account for heirs and charity. But not the zealots and maniacs it seems.

$1000 invested in a 5% yield dividend growth stock with the dividend growing at 5% a year reaches a 7.5% dividend after a bit over 6 years. $1000 invested in that stock produces a total dividend cash flow of $885.65 after 10 years of collecting dividends. That makes the end value $1885.65. That's a total return of 8.7%, lower than the zero-coupon bond. Of course that's irrelevant to the zealots and maniacs they only look at the new yield on cost which has reached 8.5%.

Another guru advocating replacing most of the bonds in the market with dividend stocks writes this:

"...bonds were not safe from the most obvious risk: Inflation. Fixed payments do not, by definition, keep up with inflation. The Incomes wondered why this was not talked about more.

The couple also wondered about the fixed-term nature of bonds. Whereas stocks, like the companies they represented, had potentially perpetual lives, at some point every bond runs out its term, and you have to figure out what to do with the money returned to you."

This displays quite a bit of lack of understanding about bonds. First off, by adjusting the maturity of a bond portfolio one increases the likelihood that bond yields will adjust with inflation. Over history bonds have offered a real return. As for his history of bonds and the assertion that bonds by nature don't keep up with inflation... these graphs tell a different story of this relationiship (source: Crestomon Research):

(Click the chart to magnify)

To be absolutely honest I have no idea what the above guru statement about bonds refers to. Here's another way to look at the relationship between bonds and inflation. It shows the compounding effect of the inflation rate over time (green) vs. returns on the aggregate U.S. bond index in red (ETF AGG) and the 1-5 year Corporate Bond Index in blue. Seems pretty clear the bond investor kept up with inflation:

(Click the chart to magnify)

Value of $1 Compunded by Inflation vs Bond Returns

The self proclaimed "dividend zealots and maniacs" think they have found a way to produce alpha. Alpha is defined as superior returns without increasing risk = higher risk-adjusted returns. They will do this successfully through stock picking and stock purchase/sale timing that will serve them well for at least the next 30 years. Label me skeptical. This site is called Seeking Alpha because it is a perpetual search with elusive if any consistent success.

Why have I presented all this? In my view, bad decisions are based on bad data evaluation. I've made my contribution as an antidote to some less than rigorous analysis. I doubt certain parties will be persuaded even to rethink their views. Clearly this article is intended for a more open-minded audience.

This represents my last word on this subject in terms of articles or comments on others' articles. I will, however respond to substantive comments on the content of this article.

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

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