Today, we’re going to continue that conversation with a chat about dividend stocks.
So, first and foremost, dividend stocks are not as safe as bonds.
A bond interest payment is a contractual obligation, meaning that if it’s not paid the company will find itself in bankruptcy court.
A dividend, in contrast, is nothing more than a distribution of profits to the company owners. The board of directors can vote to reduce it or cut it altogether for any reason — or for no reason at all. Companies make every effort to keep their dividends intact. Few things infuriate investors more than seeing their dividend slashed, but it does happen regularly.
Still, there’s several reasons to like dividend stocks, and to like them better than bonds!
All About Taxes
Dividends are generally taxed at a much more favorable rate than bonds. Most taxpayers pay only 15% on qualified dividends.
On the other hand, bond interest gets taxed at your marginal tax rate. For most taxpayers, that means a tax rate of somewhere between 22% to 32% —the highest rate being at 37%.
Let’s play with numbers…
Say you found a dividend stock and a corporate bond, each yielding 3%.
Assuming the stock’s dividends are considered qualified since most are, your after-tax yield would be 2.55%. If you’re in a 32% bracket, your after-tax yield is 2.04%. And if you’re in the 37% bracket, your yield gets bumped down to just 1.89%.
I don’t know about you, but a 2.55% yield sounds a lot better to me than a 1.89% yield.
Keeping Up with the Joneses
Inflation is low today by historical standards. But it’s still there, lurking beneath the surface.
The Fed’s inflation target is 2% per year but remember that compounds. And 2% per year over 20 years doesn’t get you to a cumulative 40%. It’s closer to 49% because of compounding.
That means the purchasing power of the interest payments you’re getting on your bond today will be nearly slashed in half after two decades.
I don’t particularly like the idea of getting poorer every year.
This is where dividend stocks really shine. Most healthy dividend stocks raise their dividends regularly. It’s not uncommon to see companies raise their dividends by 5% to 10% per year for years or even decades.
Take Walmart (NYSE: WMT) for example. The company has raised its dividend at a compound annual rate of 8.2% per year over the past 10 years. That’s enough to double the payout over that time period. Over the past 20 years, Walmart has raised its dividend by a factor of 10.
Now, what sounds better to you: Seeing your income grow 10 times, or watching it get cut in half?
Bonds mature at their face value, which is usually $1,000 per bond. If you hold a bond to maturity, that’s what you get, assuming there are no defaults or bankruptcies. Nothing more, nothing less.
That’s not necessarily all bad. Sometimes it’s nice to have that kind of predictability.
But as nice as predictability is, I’d rather have growth.
There’s no guarantee that the stocks you buy will rise in value. There are longs stretches when the market goes sideways, if not down. If you had bought the market near its top in 2000, you wouldn’t have seen a dime of capital gains until 2013.
But at least there is the possibility of capital gains with dividend stocks. A possibility flat-out doesn’t exist with bonds.
Putting It Together
I love dividend stocks. But I’ve also been doing this long enough to know that it’s a bad idea to put all your eggs in one basket.
Stocks have done well over our lifetimes. It hasn’t always been like that.
If you have a parent or grandparent that lived through the Great Depression, they know from experience that stock prices can drop like a rock and stay depressed for multiple decades.
For that reason, a good income portfolio should have a mixture of dividend stocks and safe, boring bonds.
Out of fairness to my Peak Income readers, I can’t share my favorite dividend stocks with you here today.
But if you’re looking for a nice one-stop shop for dividend growth, consider the Vanguard Dividend Appreciation ETF (NYSE: VIG). It’s chock-full of stocks with a minimum of ten consecutive years of dividend growth.