The best time to make retirement plans is right now. There are a lot of crucial decisions that you need to make to secure your financial future, and one such decision is choosing between bonds and dividend stocks. If you are not familiar with the stock market and how listed companies raise money for capital appreciation, things such as dividend-paying stocks and bond prices may be new to you.
However, these are very viable options for investing your retirement savings and this article will help you understand more about how they work. By the time you finish reading, you will be in a position to make an informed decision on which of these is the better alternative for your retirement portfolio.
Factors To Consider When Making Your Choice
Dividend-paying stocks and bonds each have their advantages. This might confuse would-be bond investors and those thinking about buying dividend stocks for their retirement. However, to make things easier, consider the following:
The size of your portfolio and how much you want to diversify
Your lifestyle preferences and the expenses that come with it
The existing sources of income that will sustain you until retirement
Your overall health and the health-related costs you are likely to encounter
The risk tolerance levels you can manage
How long your retirement may last based on your life expectancy
What Are Bonds?
A bond is an investment instrument that is issued by companies or governments as a way for them to raise money. The global bond market is estimated to be worth hundreds of trillions of dollars, making it one of the largest of all the asset classes.
When the borrower issues bonds, the agreement usually involves fixed interest rates which are paid either monthly or twice a year to the bond investors with the promise of paying the principal amount at the end of a set period. The returns that the investors will receive are based on the borrower’s ability to pay the interest on time and pay back the principal on the agreed date.
Types of Bonds and Important Terms
The following are some of the types of bonds you can invest in:
U.S. Treasuries (ranging from 3 months to 30 years in duration)
Convertible bonds (convert to stock)
Municipal bonds (issued by municipalities or different U.S. states)
Foreign government bonds (including emerging market government bonds)
Floating rate bonds (with periodic interest rate reset)
Investment-grade corporate bonds
Non-investment grade corporate bonds (junk bonds)
Before you decide to buy bonds as a means of investing your savings, you should be familiar with the following terms:
Par value: initial value of the bond
Bond rating: estimates the approximate risk of a bond defaulting
Yield to maturity: the bond’s expected rate of return based on its current price
Coupon rate: the interest payments are received as a fraction of par value
Maturity date: when the bond pays its par value
Bond prices fall or rise above par value according to the market demand. Therefore, the best time to buy a bond is when it is trading below market value, which will increase your effective yields.
What Are Dividend Stocks?
Companies can pay dividends to investors who own stock in the company. These types of stocks are called dividend-paying stocks and are paid out of a company has profits after some money has been reinvested into the business and any outstanding payments have been made.
A company may choose to offer dividend stocks as a way to attract more investors who will benefit from the dividend yield rather than just the value of the stock, as happens when they purchase non-dividend paying stocks. The tax implications on dividend stocks are based on whether they are pass-through entities or are structured as corporations.
Investing in dividend-paying stocks means you are becoming part of a company trying to raise money to finance its various income-producing activities. In return, you will not only make money when the company grows and the value of your stock increases, but the company will also pay dividends to you whenever possible.
Buying dividend stocks is easier than buying bonds because dividend stocks can be bought in very small amounts through a stock broker. To purchase bonds, you will usually need at least $1,000 for corporate bonds and $10,000 for government bonds.
Mutual funds and exchange-traded fund assets can both be used to invest in different combinations of high-quality dividend stocks.
How Do Companies Pay Dividends?
A company that has a good record of paying regular and increasing dividends can attract a lot of investors who are always on the lookout for the best-paying dividend growth stocks on the market. There are different ways through which a company can pay dividends to its shareholders, such as:
Cash deposited directly into the investor’s broker account
Companies can offer additional shares of stock as payment
They can use dividend reinvestment programs (DRIPs) where investors have the option to reinvest their dividends back into the company at a discounted price
What Is the Vanguard Dividend Appreciation ETF?
One way to track how well a company’s stock is doing and whether or not they pay dividends regularly is to use the Vanguard Dividend Appreciation ETF. This model will help create a benchmark based on the performance of different companies on the stock market and the value that investors get from its dividend-paying stocks.
Using the vanguard model, you will be able to identify certain high-performing companies, known as dividend aristocrats that will give you better and more consistent payouts than any fixed-income investment, such as bonds.
The Key Differences Between Dividend Stocks and Bonds
Investing your savings in either fixed-rate bonds or high-quality dividend stocks has the potential of giving you great returns, whichever option you choose. However, based on your individual circumstances, either one or the other may be the better alternative. To make an informed decision, you need to look at the following major differences between dividend stocks and bonds:
Stock Price Volatility vs. Par Value of a Bond
Any returns that can be expected from dividend stocks are based on the supply and demand of the stock market. This means when you invest in dividend-paying stocks you are exposed to stock market volatility. If the market turns against your company, it will negatively affect your expected dividend yield.
The par value of bonds, on the other hand, is set at the time of purchase with a known maturity date. This means from the time you buy the bonds, you should already have a good idea of how much you are likely to earn from them. These returns are guaranteed, except in extreme situations such as the company going bankrupt.
Dividends Can Be Cut
In general, a company that is doing well will pay a consistent and increased dividend to its shareholders, which is a sign to investors that buying dividend-paying stocks from that company is worth it.
However, there are certain unexpected events, such as pandemics, natural disasters, or other industry disruptions that may force the company to cut dividend stocks as a way of helping the company to survive.
Bonds do not have the same risk of being suddenly cut off without notice. While those who hold dividend stocks have to wait for the company to announce whether there will be any payouts coming, a bond investor pretty much already knows exactly when they will receive their payment and how much.
One of the advantages that dividends have over bonds is the efficiency of tax issues compared to interest payments.
Dividend-paying stocks have the advantage of a dividend tax credit, which helps the investors to keep much of their income after tax. Investors can also count on the discounts they will receive from the dividend reinvestment programs (DRIPs). This program allows them to reinvest their dividends back into the company to improve the expected returns from their portfolio.
Participating in Growth vs. Yield
An investor who holds stock from a particular company is considered to be part of that company and can take part in various discussions related to the growth of the business. This also means that when the company grows, so does the value of the stock, and investors can expect to be paid dividends.
The downside, of course, is that in times of poor growth, a company will be forced to cut dividends. Combined with falling stock prices, having their dividends cut can be a big blow to investors.
Bond investors, on the other hand, share neither these benefits nor the risks. The bond prices are par value, meaning regardless of the performance of the company, investors will still expect payments that are based on interest rates. Barring the company being shut down for bankruptcy, the principal amount will also be paid in full upon maturity of the bond.
Dividends Are Not Guaranteed
Dividend stocks cannot be relied upon to make regular payments in the same way a fixed income does. Companies are not under any obligation to offer dividend payments to their stockholders.
In fact, dividend-paying stocks are only used as a way to entice more investors to buy the stock, but it is the actual stock prices that determine whether investors will stay or not. If you are looking for an asset class that will guarantee regular payments, you will be better off targeting bond yields rather than dividend stocks.
Historically, one of the major attractions that bonds held over other asset classes, was the possibility for investors to live off the interest rates alone without having to touch their capital. Even though bonds had no value in terms of capital appreciation, their interest rates at that time were around 4% to 6%, which was great value.
However, things have changed drastically over the years. The only way for fixed-income investors to realize those kinds of interest rates is if they invest in high-yield bonds, which have a significantly higher level of risk.
This is why more and more people are turning to dividend aristocrats that have shown consistent dividend growth which will guarantee regular payments that are much higher than any fixed-income investment.
Does the Type of Dividend-paying Stocks Matter?
As we mentioned earlier, unlike bonds that rely on coupon payments based on interest rates, there are different ways through which dividend aristocrats can choose to pay dividends to their stockholders. These payments can be cash, stocks, or dividend reinvestment programs.
A company may choose any of these methods based on how well it is performing on the stock market and the type of incentives it wishes to afford its shareholders. Your choice, on the other hand, should be based on your expectations and your life situation.
Investors who are interested in capital preservation and gains are likely to choose to be paid in stocks because they will be able to grow their portfolio without the need to invest further. However, if they do not have a fixed income to rely on, the quick liquidity when cashing out on their dividend payments may be more appealing. The only thing to watch out for is that cash dividends will be taxed in the same year they are received.
Suggested Reading: Bonds Vs. Treasuries
What’s the Right Mix of Dividend Stocks and Bonds in Retirement?
One way to avoid having to make the choice between dividend stocks and bonds is to invest in both. No rule says you cannot diversify your portfolio among different asset classes. In fact, it is actually encouraged to invest that way as it spreads out the risks across different platforms, meaning if one should fail you can rely on another.
However, by taking this route you will be faced with yet another decision regarding how much to invest in each asset class. This choice is not easy, and it should be based on your individual needs and expectations. At this point, it would be prudent to approach a fee-based financial advisor who can help you with choosing the better option.
You need to make sure that the financial advisor you approach is fiduciary, meaning that they are bound by law to put your interests above their own. Other financial advisors may try to steer you towards making investments that will benefit them in some way. With regard to your personal preferences, you should consider the following factors:
The current size of your portfolio and whether it will be a good idea to invest in more than one asset class
Your level of risk tolerance because dividend stocks are riskier than bonds in many ways
How good is your health? If you need regular medical care, and therefore free access to cash, this should influence which option is better suited to you
Consider your life expectancy and how many years you expect your retirement to last
If you have an expensive lifestyle then choose an option that will allow you to finance that kind of life
The existence of other income sources will reduce your reliance on your retirement portfolio and therefore allow you to consider long-term investment options
Whichever option you end up choosing, the important thing is to diversify as much as possible while not leaving yourself overexposed to unnecessary risk. Most investors agree that between 5% and 10% of your entire portfolio should be dedicated towards investments, with the rest remaining safely secure in more reliable accounts, such as a 401(k).
Of that 5% to 10%, history suggests that holding most of your money in stocks will be more profitable in the long term than investing primarily in bonds. This means that you should ideally be looking at dividend-paying stocks to make up the bulk of your portfolio with a few bonds added in for diversification.
Choosing between dividend stocks and bonds can be made a lot easier by investing in both asset classes with the help of a financial advisor. Whether you are leaning towards the returns offered by high-quality dividend stocks, or you would prefer the relative safety and predictability of bonds, is up to you.
Two things you cannot afford to do are to make an uninformed decision and to invest in a single asset class. These mistakes will expose you to a lot of unnecessary risks. Having said that, the differences between the two asset classes discussed in this article have been clearly outlined, which will help you secure your financial future in the best possible way.