In an era of low bank CDs and bond interest rates, we have been increasing our allocation to high quality dividend stocks or “bond like stocks” while reducing our investments from CDs and bonds. This strategy is especially attractive when the dividend yield of the S&P 500 is higher than the bond yield on the 10 Year US Treasury bond (see chart below).
Where is the yield? Stocks versus bonds…
Source: Bloomberg
Institutional approach…
Institutional investors (pension funds) invest into securities (stocks, bonds and CDs) for income and appreciation. In the short and near term, they prudently meet their liabilities to pay their retirees with the income they earn from securities. They are indifferent to whether the income comes from a security that is a stock, bond or CD if they are of equal quality. From the mid 1970s to 1982, institutional investors invested more into CDs and less into stocks and bonds as interest rates were high and rising. From 1982 to now, institutional investors have shifted out of CDs to both bonds and stocks (declining rates make their yields more attractive). From early 2009 to now, they have rotated into dividend yield stocks and away from bonds, especially when the S&P 500 yield exceeded that of the 10 Year US Treasury.
Publicly listed corporations are also institutional investors. When dividend yields are higher than bond yields, like now, they refinance their liabilities (debt and stock) by issuing lower yield bonds and buying back their higher yielding stocks. US corporations saved a lot of money this way and it explains why they have been big buyers of their stocks since 2009.
Don’t compromise on quality when investing for income…
Stocks and bonds have different quality ratings. These ratings focus on the ability of the issuers to pay interest/dividends and the principal upon maturity for bonds (for stocks, this reflects the avoidance of bankruptcy and the potential for stock price appreciation). Individual investors investing for income have a hard time monitoring credit trends, credit spreads and end up taking abnormally high risk. Too often I have seen them buy excessively high yield stocks or bonds only to lose most, if not all, of their original investment. The highest yields often reflect declining financial health rather than a good investment opportunity.