In the first part of this series, we examined some of the risks of owning both stocks and bonds with the purpose of generating income in mind. In this segment, we’ll compare some of the potential rewards of each of these asset classes.
First and very simply, at the present time, a portfolio of U.S. high quality companies provides a yield higher than that offered by a 10-year treasury bond (2.2 percent or more vs. 1.7 percent). Beyond this basic comparison, income from stocks offers other potential advantages:
Increasing income – Historically, over time, companies have tended to raise their dividend payout as the company and its profits grow. The general rate of increase in the last few decades has been in the 6 to 7 percent range, meaning that dividends have risen faster than the rate of inflation. Some companies raise their dividends more aggressively, providing even more benefit to shareholders.
When the government issues a traditional 10-year treasury bond it does not increase the interest payment each year, meaning that in the year the bond matures, the owner is receiving the same rate as he or she did in the year the bond was issued. We would expect that if historical trends continue, the stock portfolio’s income level may double or even triple during a 10-year period.
Preferential tax treatment – Under the current tax code, dividends from common stocks are taxed at a maximum of 15 percent, where interest paid by the 10 year Treasury bond is taxed at ordinary income rates (as high as 35 percent). We don’t know what will happen with tax rates on ordinary income or dividends, but there is a good chance that both rates will go up. But even if dividends from common stock no longer receive preferential treatment, we still have a favorable apples to apples comparison between these two potential income sources, which shows stock dividends to be superior, and with potential increases over time, it becomes an even better story.
I’d like to share a few other thoughts as you consider stocks and bonds for generating portfolio income. For many investors, bonds will remain an important component of the portfolio despite the conclusion that, stocks may be superior long-term income vehicles. The primary reason for this is risk control. Stocks are generally more volatile than bonds and these two asset classes often move in different directions, providing risk reduction by owning both.
I believe the main point here is not to abandon bonds, but to at least consider the long-term advantages of equities from an income standpoint. I would also urge you not to blindly buy the highest yielding equities you can find. Often the very high yields may be a sign of impending trouble, perhaps even a dividend reduction or elimination. We prefer instead to invest in companies which are actively raising their dividends on a regular basis, even if the current yield is a bit lower. These companies tend to be healthier financially, better able to handle the business cycle’s challenges and should provide, we believe, a better return over time.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.