The Dividend Investing Blog

Dividend investors will often face the bond dilemma. As a dividend investor, we seek steady income while reducing risk.  Inevitably someone will ask you, “Why invest in risky dividend stocks when you can buy bonds?”. This is a fair question and one that has an easy answer and a complex answer.

From Investopedia:

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate.

There are many different types of bonds and this is where the answer to the stock versus bond question becomes complex. For now, we will focus on standard bonds that pay a fixed rate over a fixed duration of time. For example, a 10-year $1,000 par value bond paying 4% would give you regular payments every six months of $20.

So what’s wrong with that? There are a couple of problems with bonds.

• Taxes
  You will usually have to pay your regular income tax rate on interest from bonds. If you are in the 28% tax bracket, then the $40 you earned on the bond becomes $28.80 after taxes. Instead of 4%, your yield on the bond is 2.88%. Conversely, if you had purchased a stock with a 4% dividend, then you would pay 15% in taxes yielding 3.4% after tax.
• Inflation
  There is no guarantee that your stock investment will grow, but most of the time the price of stocks will rise with inflation at a minimum. This means your yield on cost is growing as well. On the other hand, the 10-year bond par value is not growing. The $1,000 you invested in the bond will be worth $1,000 in ten years. If the inflation rate averages 3%, then you are effectively losing money on this 4% bond. Why? We saw previously that after taxes the bond was yielding 2.88%. If we include inflation, then we are actually yielding -0.12%.

Bonds are a safe investment that provide reliable income. As I mentioned before, there are many different types of bonds. There is one class of bond that addresses the two problems of taxes and inflation. These are called inflation-indexed bonds. How well do these bonds compare to dividend investments? Find out in an upcoming article.