When investing there are two attributes that determine performance-. They are income and capital appreciation. Some types of investments provide just income, others provide a combination of income and capital appreciation, and still others just provide capital appreciation.
A savings account is the best example of an investment that just provides income. An investor collects interest income and there is no change in the value of the principal.
An investment in bonds has some similarities to the savings account investment. Both provide interest income, but the value of the bond can fluctuate depending upon changes in interest rates. Therefore, an investment in bonds is somewhat riskier compared to a savings account.
Stocks are good example of an investment that provides both income and the potential for capital appreciation. Income producing real estate also provides these same characteristics.
There are some stocks that provide no dividends, where the only reason for holding the asset is the potential for capital gains. Likewise, other investments such as raw land or gold do not provide any income. Generally investments that provide no income are considered the riskiest.
Looking at the current environment, as of last Friday, the yield on stocks, as measured by the S&P 500 was 2.1%. For bonds the yield on the 10-year Treasury was 1.75%. In recent years, yields for both have been hovering around the 2% level.
Prior to recent years bond yields were generally higher than the dividend yield for stocks. However, prior to the 1960’s there were other time periods where bond yields were greater than stock dividends.
When looking at the income from bonds there are several things that impact the yield. These would be the maturity of the bond, its riskiness, and its tax status.
Bonds with longer maturities generally provide more income versus shorter-term bonds. Bonds from less seasoned companies provide more income versus safer government bonds. Municipal bonds provide less income because they are tax free. U.S. Treasuries are taxable at the federal level, but exempt from state tax, which in California is significant.
For stock investors dividends can vary significantly by the type of company. Generally companies in slower growth industries like Utilities pay higher dividends, while some faster growth companies don’t pay a dividend at all.
Many companies besides paying a dividend buy back their stock. In theory, if there are less shares outstanding, the value of a smaller base of remaining shares should increase. For taxable investors capital appreciation is generally preferable to dividend income, since dividends are taxed when received albeit at a favorable rate, while capital gains can be deferred until the stock is sold.
A major advantage of dividend income versus interest income is that dividends generally increase over time, while the interest payment on bonds is fixed. Therefore, while current stock and bond yields are comparable, over time the investor in stocks should receive greater income.
While most companies tend to raise their dividends each year, sometimes in recessionary periods dividends can be cut, or even eliminated. Also, a stock performing poorly with a high dividend yield could be candidate for a dividend cut. Investors in high yield, or “junk bonds” also face the possibility of not receiving their interest payment during difficult economic times.
Just looking at current yields stock appear more attractive relative to bonds because of their potential for dividend growth and capital appreciation, which bonds don’t have. However, in a recessionary environment bonds will likely perform better than stocks. Therefore, except for aggressive investors, it would still be appropriate to maintain some investments in bonds and/or money market accounts for diversification purposes.