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Stocks vs Bonds for income



May 22, 2009 – Comments (10)

A traditional model for investors is something like 100 minus your age = the percentage of the portfolio that should be in stocks with most of the remainder allocated to bonds.  Since I’m 50, this model would say half my portfolio should be in stocks with something like 40% in bonds and 10% in cash.  In today’s market, I think that allocation understates the inflation risk in bonds and doesn’t account for how far some solid, dividend paying stocks have fallen.

To illustrate, let’s project what could happen with a portfolio of blue chip, dividend paying stocks.  For this exercise, we’ll look at a portfolio equally weighted across Johnson and Johnson (JNJ), 3M (MMM), McDonald’s (MCD), Procter and Gamble (PG) and Emerson Electric (EMR).  These are all S&P Dividend Aristocrats, have good dividend yields and reasonable payout ratios.


 A portfolio spread evenly across these five stocks would have a current dividend yield of 3.65%.  For comparison the current yield on the 30-year Treasury is 4.34%, the 10-year is 3.39%.  You may ask, why would an investor take on the risk of stocks for income when they can nearly match the rate with a 10-year bond or beat it with a 30-year bond?  The answer - the coupon payment on those bonds is fixed, not so with the stocks.

I calculated the 5-year and 10-year compound average dividend growth rates for these five stocks.  To be conservative, I assumed they would continue growing dividends at 85% of the lower of the two growth rates.  McDonald’s CADGR was, in my opinion, unsustainable so I arbitrarily capped it at a 12% dividend growth rate.  The results for the five-stock portfolio are plotted below.  Photobucket isn't linking, so if the chart isn't here, the projected dividend yield on the initial investment by year is also listed.

2009  -  3.65%
2010  -  3.96%
2011  -  4.30%
2012  -  4.68%
2013  -  5.08%
2014  -  5.53%
2015  -  6.02%
2016  -  6.56%
2017  -  7.15%
2018  -  7.80%
2019  -  8.50%


A key point for income investors is that the stock price going forward isn’t particularly important as long as the company has the ability to continue paying and raising the dividend.  That said, the current market also offers significant upside potential for names like these as well.  If the stocks in this hypothetical portfolio were to trade back up to their 5-year average dividend yield, our investor would be looking at a 61.5% increase in the portfolio’s market value.  Of course, it’s also possible the stocks could fall in price.

Investors who don’t need the current income can get a double dose of compounding by reinvesting the dividends.

The characteristics I look for in income producing stocks are:
Good current yield
Track record of dividend hikes
Payout ratio below 50%
Growing earnings – some slack here during a recession, but not much

Warning signs are stocks with much higher dividend yield rates than their peers combined with a high payout ratio and earnings trouble.  Those are signs that the market is expecting the dividend to be cut.

Good places to start searching for stocks like these are the S&P 500 Dividend Aristocrats and Indxis Dividend Achievers.  S&P’s Dividend Aristocrats are members of the S&P 500 that have raised their dividend every year for at least 25 consecutive years.  There are currently 52 stocks on that list.  Indxis Dividend Achievers cover the broader market with 12 different lists.  Their Broad Dividend Achievers Index includes US companies that have increased their dividends for at least ten consecutive years and have at least $500,000 per day of average trading volume.  There are currently 283 stocks in that index.  Here on CAPS, fellow Fools sagitarius84 and Dividends4Life frequently post blogs analyzing dividend paying stocks.

I wouldn’t recommend completely abandoning bonds in a portfolio, but replacing part of a traditional portfolio’s bond allocation with select dividend paying stocks is worth considering at these depressed stock prices.

Disclosure, I’m long MCD and JNJ.

10 Comments – Post Your Own

#1) On May 22, 2009 at 1:33 PM, speedybure (< 20) wrote:

Bonds are an absolute death trap right now, even high yield. Only because we are in for a massive wave of inflation, the likes the U.S has never seen. Even Tips are worthless because CPI is an arbitrary basket (you can't measure human capital, ect). International bonds will likely be lucrative in the near future, especially corporate. IB allows you to purchase them on other exchanges

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#2) On May 22, 2009 at 1:43 PM, FleaBagger (27.53) wrote:

I would recommend everyone abandoning US treasuries at this point, and youngins investing in TMV.

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#3) On May 22, 2009 at 2:17 PM, FreundInvesting (28.73) wrote:

It's actually 120 minus your age now, since people are living longer.

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#4) On May 22, 2009 at 2:27 PM, RonChapmanJr (30.30) wrote:

What Ryan said - 120 - age

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#5) On May 22, 2009 at 2:36 PM, speedybure (< 20) wrote:

even a 6-8% after tax return is terrible as it will likely be negative in real terms, or at least 1 to 2% at best. Look at the cnadian oil trusts, even though they are loosing their tax exempt status many offer 6-11% div yields after the cut. We all know oil is going higher, so a high dividend + price appreciation makes bonds look like dog ***. There are so many oportunities in international equities which you can buy on such brokers as IB. I have found ridiculous valuations for great companies in canada, new zealand, australia, hong kong, etc. This is not the time to even think about bonds. Even those who are aging are better off the merck hard currency fund to at least protect their wealth from inflation. The government continues to pump capital every way possible and this will inevitably end up crushing the dollar. 

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#6) On May 22, 2009 at 3:33 PM, rd80 (95.56) wrote:

Ryan and Ron - Thanks for correcting the stock-bond rule of thumb.

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#7) On May 22, 2009 at 3:47 PM, bobtoni (< 20) wrote:

I agree with flea bagger even if his name doesn't sound like he's a member of mensa. (I'm 76 by the way). Whether golf or investing, I never found being too conservative was a profitable move. I don't need slot machines or Las Vegas, just let me read the Fool and I'm happy.

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#8) On May 27, 2009 at 8:26 PM, tolstoy00 (65.17) wrote:

I'm 24 and I was considering bonds to a certain extent in my portfolio. But after reading this post along with the comments, I realize that bonds and some other fixed investments such as CD's and TIPS are not the way to go for investment money at this point.  

A lot of interesting and valid points were made here, especially about the value of international stock exposure and the value of solid dividend paying companies. Thanks. 

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#9) On May 27, 2009 at 8:40 PM, portefeuille (98.82) wrote:

100 minus your age = the percentage of the portfolio that should be in stocks with most of the remainder allocated to bonds.

Should a 110-year-old be 10% short stocks and 110% long bonds?

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#10) On May 27, 2009 at 11:07 PM, rd80 (95.56) wrote:

port - I'll be sure to find some stocks to short when I reach 110.  But, I like the 120 rule better, that way I don't have to start shorting until I'm 130 :)

tolstoy00 - Investing for the future at 24 is awesome.  Nearly everyone approaching or in retirement will tell you the same thing - I wish I had started earlier.  Congrats on actually starting earlier.

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