Wednesday, September 23, 2009

Dividends Stocks versus Fixed Income

Many retirees who are seeking current income from their assets invest in fixed income securities, most of which provide a stable stream of income. Fixed income investments do have some disadvantages relative to stocks that pay dividends, and thus retirees which fail to account for these, could end up with no income at the worst time possible .

First, while typical fixed income securities provide a dependable income stream, its purchasing power is typically eroded by inflation. Even at 3% per annum, the purchasing power of one dollar decreases by 50% in 24 years. Double that inflation rate to 6% annually and now the purchasing power of one dollar is down by 50% in 12 years and by 75% in 24 years. Stocks that pay rising dividends provide the best inflation proof source of income. Dividend based distributions can grow, interest based distributions usually don't. Unless interest income is reinvested, the interest income cannot grow over time to compensate for the eroding value of inflation.

Second, right now qualified dividend income is taxes at 15% for the highest tax bracket in the US, which is almost half the top tax for interest income in the States. In Canada dividend income also received a preferential treatment relative to fixed income.

Third, bonds typically don’t increase their interest payments if the business is doing well. Stocks, which represent partial ownership of companies, tend to share higher profits with shareholders either through dividend increases or through stock buybacks. Thus stocks tend to provide higher total returns over time as they could provide higher capital gains and higher dividend incomes.

Stocks have disadvantages as well however.

First, if a company goes under and declared bankruptcy, fixed income holders are the only ones that get at least some return of their investment. Stockholders on the other hand typically receive nothing when the company emerges from bankruptcy.

Second if a company faces financial difficulties it could easily afford to cut or eliminate its dividends, but it would have to go through huge hurdles before it could get bondholders to agree to reduce or eliminate their interest payments.

Fixed income securities guarantee a return of your investment some time in the future, whereas stocks don’t provide that.

That being said I do believe that the best strategy for long-term investors is to have an allocation to both stocks and bonds. Fixed income tends to provide dependable income even in the worst bear markets. In addition to that fixed income investments provide diversification in bear markets and are the only asset to provide returns to investors during deflationary periods.

Stocks are great vehicles to own during average and high inflationary periods, and they could provide investors with rising inflation adjusted streams of dividend income over time. There are companies which have long records of raising their distributions. The possibility of receiving rising dividends from stocks, make equities a preferred method of investment for many investors. Some early holders of stocks like Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Altria (MO) are now enjoying double or even triple digit yields on cost on their original investments, even without reinvesting their dividends. Similar investments even in the safest highest yielding fixed income securities would still be generating the same incomes, provided that they have not matured.

Currently I like several dividend stocks, which have the best prospects to grow their distributions over time.

Johnson & Johnson (JNJ) has increased dividends for 47 consecutive years. Johnson & Johnson engages in the research and development, manufacture, and sale of various products in the health care field worldwide. Check my analysis of the stock.

Mcdonald’s (MCD) has increased dividends for 32 consecutive years. McDonald’s Corporation, together with its subsidiaries, franchises and operates McDonald’s restaurants in the food service industry worldwide. Check my analysis of Mcdonald’s.

Chevron (CVX) has increased dividends for 22 consecutive years. Chevron Corporation operates as an integrated energy company worldwide. Check my analysis of Chevron.

Abott Labs (ABT) has increased dividends for 37 consecutive years. Abbott Laboratories manufactures and sells health care products worldwide Check my analysis of the company.

Clorox (CLX) has increased dividends for 32 consecutive years. The Clorox Company manufactures and markets a range of consumer products Check my analysis of the stock.

Full Disclosure: Long ABT, CLX, CVX, JNJ, MCD, MO

Relevant Articles:

- The case for dividend investing in retirement
- High yield stocks for current income
- Dividend Cuts - the worst nightmare for dividend investors
- Determining Withdrawal Rates Using Historical Data

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