Stocks or Bonds for Income??
Let’s do a prediction for two different approaches to generating an income stream from a nest egg. For this simulation, I’m going to look at the pre-tax and after tax income streams over 10 years from a $500,000 investment. One portfolio will be in 10-year treasuries, the other equally divided between four dividend paying stocks, CVX, T, RPM and WFC. I picked these because they have above average yields that are well covered by earnings and good histories of dividend increases – and I happen to own these four so it's somewhat relevant to me.
For the 10-year treasury, I’ll use the yield from the 7 Sep 2007 market close. For income paying stocks, I’ll use the share price and dividend payouts as of the same market close. To be a little conservative, the assumption in the model is that the stocks in the dividend portfolio increase their annual payouts by eight-tenths of their average increase over the past ten years. For example, if XYZ company has increased their dividend by an average of 5% per year over the past ten years, the model projects a 4% annual payout hike to be conservative.
Results of the simulation are shown below (sorry for the graphics quality). At the end of their first year, the bond portfolio is a clear winner. By year five, the stock portfolio’s income stream has caught up with the bonds. By year 10, it’s nearly 50% higher than the bond portfolio’s.
What happens if the nest eggs are outside of a tax advantaged plan? I’ve assumed a 28% tax bracket and that the current law taxing qualified dividends at capital gains rates is in effect for the duration of the model. The dividends would be taxed at 15%, while the interest is taxed as ordinary income at 28%. Note: I haven’t taken state taxes into account, interest from U.S. Government bonds would not be subject to state taxes, dividend income would be. The bond portfolio generates $15,700 after taxes every year for the ten year duration. The dividend paying stock portfolio generates a little over $13,800 after taxes the first year. It passes the bond portfolio’s flat after tax income level in year 3 and is cranking out $26,600 of after tax income in year 10. The results are shown below.
No investment analysis is complete without a look at the risks involved. The bond portfolio has virtually no investment risk – the US government is very unlikely to default on its bonds, so the interest payments and bond principle repayment at maturity are a virtual certainty. However, inflation is also a near certainty, so the level income stream won’t have nearly the buying power in year ten that it did in year one. There’s also a reinvestment risk when the bonds mature since there’s no way to know what bonds will yield in the future. The model could be run with longer duration bonds which would push the reinvestment risk out but wouldn’t eliminate it. Other strategies like laddering the bond portfolio can help to reduce the reinvestment risk, but can’t eliminate it.
The stock portfolio faces the same inflation risk, but since the dividend payments are expected to increase over time, the investment income stream should also increase over time. Of course, there is no way to guarantee the dividend payouts will out pace inflation. There are also investment risks. Among those risks, the companies may not raise their dividends as predicted, the dividend payments could be cut or even eliminated and congress could end the preferred tax treatment of dividends. Some of that risk would be mitigated by holding a diverse portfolio of several stocks and choosing solid companies with strong businesses. Note that for this model, the only time the price of the stock is important is when it’s purchased. Also note that, assuming the businesses stay solid, an investor looking for income may never need to reinvest.
I realize this is a simplistic analysis and that there are a number of investment options and strategies for generating income beyond to two examples presented here. Combinations of Treasure Inflation Protected Securities (TIPS), preferred stock, corporate bonds real estate and other securities are all approaches that could be considered.
Many years ago, conventional wisdom was that someone retiring should have the vast majority of their portfolio in bonds. Within the last 10 – 20 years or so, that’s shifted to a mix of stocks and bonds with a common rule of thumb that the percentage of the portfolio invested in stocks should be about 100 minus the investor’s age. After seeing the results of this simple model, perhaps even the new allocation rule-of-thumb underestimates the amount of stock exposure most investors should have in their portfolios.
As time allows, I hope to be able to expand and update this with some probabilistic analysis or Monte Carlo simulation and expand to look at equity-income mutual funds and the relatively new dividend weighted ETFs from WisdomTree as alternatives to holding individual stocks. My gut feel is that the mutual funds will have a difficult time being competitive. Since a big chunk of stock returns are from dividends, especially for income producing stocks, logic would dictate that taking a 1% or so management fee off the top of a 2-4% dividend stream will be a tough headwind to overcome.
Have a great week and thanks for reading.