Bond yields in 2022 touched their highest level in more than a decade following the historic loss most bond funds experienced as the Fed hiked interest rates to fight rampant inflation.
With many bonds now sporting similar or higher yields than dividend stocks, income investors may wonder if it makes sense to allocate more of their savings to these lower-risk securities.
Both types of investments can play important roles in funding living costs during your golden years. But they each possess unique risks, too.
After reading this guide, you will understand the:
- Key differences between bonds and dividend stocks
- Risks of investing in an all-bond portfolio
- Benefits of owning dividend stocks and bonds for retirement income
Let's start with a brief overview of each asset class.
What are Bonds?
Bond issuers make a promise to repay investors' principal at a certain future date and make periodic interest payments along the way.
Most bonds are sold in increments of $1,000 or greater and pay fixed interest payments, which are usually distributed semiannually and generate almost all of a bond's total return.
As long as the entity issuing a bond repays it in full and makes each interest payment, the bond investor earns a set, predictable rate of return.
Many types of bonds exist for investment:
- U.S. Treasuries (ranging from 3 months to 30 years in duration)
- Foreign government bonds (including emerging markets)
- Investment grade corporate bonds
- Non-investment grade corporate bonds (junk bonds)
- Municipal bonds (issued by U.S. states or municipalities)
- Floating rate bonds (interest rate resets periodically)
- I bonds (inflation-adjusted savings bonds)
- Convertible bonds (convert to stock)
- Mortgage-backed bonds
Some of the most important metrics for bond investors to know are:
- Face value: initial value of the bond
- Maturity date: when the bond pays back its face value
- Coupon rate: annual interest payments received as a percentage of face value
- Yield to maturity: the bond's expected rate of return based on its current price assuming it is held until its maturity date and makes all interest and principal payments
- Credit rating: estimates the risk of a bond failing to make its promised payments, per research from credit rating agencies such as Moody's
Investors can buy most types of individual bonds through their broker, just like with stocks.
Courtesy of Schwab, here's a look at the best yields available across different fixed income securities and maturity ranges (as of January 24, 2023):
Clicking any rate above reveals all of the individual fixed income securities you can buy, including their coupon rates, maturity dates, and credit rating:
However, the simplest method of investing in fixed income assets is through a diversified fund, such as the Vanguard Total Bond Market ETF (BND).
What are Dividend Stocks?
Most dividend payers have mature businesses that generate solid cash flow. They can be found in every sector of the stock market, from industrials and real estate to consumer staples and utilities.
Dividends are paid out of a company's profits, after it has made interest payments on any outstanding debt and reinvested back into the business.
As a company grows its earnings over time, dividends usually follow.
For example, Coca-Cola, a dividend king, has increased its dividend by approximately 8% annually over the last 20 years.
As a Coca-Cola shareholder, you would have received 40 cents in dividends for every share you held in 2002.
By 2022, without making any further contributions, each share you owned would have received $1.76 in dividends.
And Coke's share price would have more than doubled as the firm's higher profits also increased its value, resulting in a healthy total return.
Simply put, owning stock gives you exposure to the upside (and downside) of a company's performance.
Dividend investors can assemble their own portfolios of individual dividend stocks or gain exposure through dividend-focused funds such as Schwab U.S. Dividend Equity ETF (SCHD).
With the basics of bonds and dividend stocks behind us, let's look at the key differences between them.
Key Differences Between Dividend Stocks and Bonds
Bond Payments Take Priority
In general, bonds are the most senior form of capital an organization has, meaning that these obligations get paid first.
Thus bonds are considered "senior" to all forms of equity, with preferred equity coming second and common equity (which encompasses dividend stocks) coming last.
Even junk bonds (high-yield bonds) have relatively low default rates, including under 4% over the past 30 years and a peak default rate of 18% during the 2007-09 financial crisis.
For comparison, around one-third of S&P 500 dividend-paying companies reduced or suspended their dividends during the financial crisis.
Bond payments always take priority over dividends.
Bonds (Usually) Have Lower Returns and Price Volatility
The table below shows historical returns from 1926 through 2022 for portfolio allocations ranging from 100% stocks to 100% bonds to demonstrate the tradeoff between risk and reward.
Holding more in stocks has historically delivered superior annual returns. But an equity strategy also experiences more short-term losses (sometimes severe) that can make it harder for an investor to stay in the game without panicking.
Bonds Can Be More Sensitive to Inflation and Interest Rates
Unlike dividend stocks, which often grow their dividends faster than inflation, fixed-rate bonds have no inflation protection.
When inflation expectations rise, interest rates tend to rise with them as investors demand a higher yield to compensate them for higher expected inflation.
As a result, bond prices fall so that the effective yield (coupon payments divided by bond price) matches the prevailing interest rate for that type of bond. If you need to sell a bond before maturity and rates rise, you can lose money.
For example, an index tracking fixed-rate debt issued by the U.S. Treasury with 20-plus years to maturity lost around 39% in 2022. This was the worst performance in over 200 years.
But Treasury bonds with maturity dates between 2 and 10 years were only down about 11%, according to CNBC.
With the 2022 rout in bonds ushering in higher yields, some investors may wonder if now is a good time to allocate more of their portfolios to fixed income.
Should I Invest in Bonds for Retirement Income?
As the chart below shows, stock and bond returns have historically had low or even negative correlations in different developed markets worldwide.
In other words, assuming this relationship continues to hold, if the S&P 500 fell into a correction, then bonds would be expected to decline much less or even appreciate in value.
Owning some bonds can reduce a portfolio's drawdown to soften the blow to its equity investments and help investors stay the course.
But what if you could ignore price fluctuations and live off bond interest alone? With many bonds now yielding 4% or higher, is this a good idea?
The Risks of an All-Bond Portfolio
- Retire at age 60
- Have $1 million to invest
- Need this money to last at least 30 years
- Withdraw $40,000 per year (4% withdrawal rate) for living expenses
- Adjust your withdrawals higher by 3% annually for inflation
If you held your money in cash, you'd run out of funds in less than 20 years.
You have to take some risk by investing to make the numbers work.
But maybe the stock market feels too scary. Could it make sense to own only bonds?
There are a few challenges with this plan.
If you do not invest in bonds with maturities that match your 30-year time horizon, you will face interest rate risk.
For example, a 1-year Treasury bill offers a 4.7% yield (up from 0% in late 2021) thanks to the Fed's short-term rate hikes.
While this would exceed your 4% withdrawal rate, it may not last.
Assuming inflation is tamed and retreats towards 2% to 3%, the yield on a 1-year Treasury will likely follow as the Fed reverses some of its rate hikes.
As this plays out and your Treasury bill holdings mature in a year for reinvestment at lower rates, your interest income will fall and fail to cover your withdrawals, eating into principal.
You could buy a 30-year U.S. Treasury note to eliminate interest rate risk. But these securities only yield around 3.7%.
That gets you close to your 4% withdrawal rate. But the gap widens over time as the interest payments remain fixed but your withdrawals increase due to inflation.
When withdrawals exceed interest income, you'll need to raise additional cash by selling some of your bond holdings.
This creates a downward spiral where a smaller holding of bonds results in a smaller amount of interest income generated, resulting in the need to sell even more bonds to fund the gap.
The end result is a shrinking portfolio that is unlikely to last 30 years.
The chart below plots the balance of a theoretical $1 million portfolio invested in a 30-year Treasury yielding 3.7% with $40,000 of annual withdrawals, adjusted 3% annually for inflation.
The projection would look even worse if these bonds were held in a taxable account since their interest payments are taxed at ordinary income rates (excluding municipal bonds).
Owning a mix of bonds and dividend growth stocks can provide an appealing alternative.
Making the Case for Owning Dividend Stocks and Bonds
Dividends paid by S&P 500 companies have historically grown around 6% per year over the long run.
Investors can assemble a portfolio of quality dividend stocks yielding 3% to 4% and able to grow their dividends by 5% to 7% annually.
Pairing this portfolio with fixed income securities that now yield around 4% can provide a solid mix of current income and inflation-protected income growth. All without having to sell any shares.
For example, suppose your $1 million portfolio was allocated 60% to dividend stocks with a 3% yield and a 4% dividend growth rate. The remaining 40% was used to purchase 30-year Treasury notes yielding 3.7%. And annual inflation runs at 3%.
An initial withdrawal rate of 4% ($40,000) would be met using dividends and bond interest, with any gap filled by selling part of the bond portfolio. The stocks would be left untouched.
We estimate the bond portfolio would not be depleted for 23 years. At that point, the dividend portfolio's annual income stream would have grown from $18,000 to over $42,000.
That wouldn't be enough to cover annual withdrawals that inflation had pushed up to around $75,000.
But if the portfolio continued to trade at a 3% dividend yield, it would have a market value of approximately $1.4 million – more than the initial $1 million investment made across stocks and bonds.
With less than 10 years left in our original 30-year time horizon, that would be plenty to cover future withdrawals and then some.
Wall Street Journal columnist Jonathan Clements explored this concept in 2015, when bond yields were much lower. He reached a similar conclusion.
Closing Thoughts on Dividend Stocks and Bonds
Dividend stocks can provide a powerful foundation for generating reliable income with good potential to outpace inflation, a quality bonds will never have.
If you are interested in a dividend strategy to generate retirement income without needing to sell any shares, you might be interested in our online product, which lets you track your portfolio's income, dividend safety, and more.
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