Should investors use equities in lieu of bonds to meet their income needs?

The case for investing in equities to meet income needs is compelling, particularly in light of today’s higher inflationary expectations. Higher levels of inflation are typically negative for fixed income returns, while equities can provide an inflation hedge, as a company’s revenues and earnings can be expected to rise in tandem with prices. In addition, not only can certain stocks provide higher levels of current income compared to fixed income, but they also have the ability to grow their dividends over time. Investors have a unique opportunity to use equities in lieu of bonds to meet their income needs. In this era of low bond yields and higher inflationary expectations, Haverford believes it is appropriate for income-oriented investors to consider increasing their allocation to high-quality equities in order to meet their income goals.

With the dividend yield on the S&P 500 reaching 1.4% this year, dividends may not be quite as  generous as they once were. However, compared to the low levels of treasury yields, equities can still provide a decent level of income. Today, 229 companies in the S&P 500 Index sport dividend yields greater than the average yield on ten-year U.S. Treasury bonds.

We believe Pepsi stock represents a good example of the opportunity to achieve both high levels of current income and dividend growth potential. The company’s ten-year bonds currently yield 2.1%. If investors hold the bond until maturity, they will receive an annual return of 2.1% over 10 years. Alternatively, one can buy the common stock, which currently pays a 2.7% dividend yield and carries a reasonable probability based on historical performance that the dividend will grow by about 7% a year. After ten years, the yield on the original cost of the stock would grow to be 5.3%, more than twice the income that could be achieved on the company’s bonds. If the common stock remains at the same price ten years from now and assuming that earnings grow by 7% per year, the price-to-earnings (P/E) multiple will be 13X. PepsiCo is just one example that highlights the current disconnect between stock and bond pricing.

While very compelling, using equities to meet income needs is not without risk. Equities are significantly more volatile than bonds. In addition, the dividend payments are less secure than a bond interest payment. For many investors, these risks could well be worth taking, especially after considering that fixed income investing carries risks of its own, possible loss of principal if interest rates rise significantly. One of the larger risks a fixed-income investor faces is out-living their money as inflation and taxes slowly erode one’s purchasing power. Equities, on the other hand, can provide at least some hedge against inflation.

We believe it will be advantageous for yield-oriented investors to change their point of reference when reviewing portfolios. Less attention should be placed on the daily volatility of stock prices, and an increased focus should be placed on the history, trajectory, and sustainability of a company’s dividend payment. This focus will enhance the probability that investors’ long-term income needs are met.

Stocks with Dividend Yields Better Than Their Corporate Bonds

These 25 stocks, which are included in Haverford’s Quality Investing portfolios, represent 17 distinct industry groups and have a current average yield of 2.9%.

Dividends are not guaranteed and will fluctuate.  Dividend-yield is one component of performance and should not be the only consideration for investment.

The opinions expressed herein are those of Haverford. Views and security holdings are subject to change at any time based on market and other conditions. This article is for informational purposes only and should not be construed as investment advice with respect to the information or securities presented. No forecasts are guaranteed and past performance is no guarantee of future results. Information is derived from sources believed to be reliable, however, we cannot guarantee its accuracy. Data as of 10/21/2021.