An investor looking for income producing market trade investments has a choice of bonds or dividend paying stocks. Although she may find bonds and stocks with similar yields, the characteristics of bond interest and stock dividends are significantly different. The best choice depends on the individual investor's investing goals and risk tolerance.
A bond is a debt security issued by a corporation or government entity. The typical bond pays a fixed annual rate of interest and the face amount of the bond is paid out to the investor when the bond matures. Most bonds split the interest into two semi-annual payments. The quoted yield-to-maturity of a bond is the best measure of the return an investor will earn based on the bond's current market price and rate of interest payments. Bond yields vary by current market rate levels and a bond's specific credit rating.
Stock dividends are a portion of a corporation's profits paid out to shareholders. Each company decides the level of dividends it wants to pay. Corporations with a policy of regular dividend payments typically make a distribution every three months, or quarterly. The current yield of a dividend paying stock is the most recent quarterly dividend times four, divided by the stock price. The yield of a stock will fluctuate as the share price moves up and down due to market forces.
Guaranteed vs Not
A distinct advantage of bond yield over stock dividend yield is the guaranteed nature of bond interest. Once you purchase a bond, you will receive the fixed interest payments until the bond matures. However, there is a risk of not earning the interest if the issuer defaults. Buying high rated or government bonds keeps the default risk near zero. In contrast, a company can change its dividend policy at any time, reducing or eliminating future dividend payments. Each dividend a company pays must be voted on and declared by the company's board of directors. If a company has outstanding bonds as well as an obligation for dividend payments, it must pay bond interest first.
Growing Income Stream
An advantage of dividends is the possibility of a growing dividend payout rate over time. Many companies have a history of increasing dividend payment amounts year after year. The 2011 Dividend Achievers list from Mergent included almost 200 stocks that had increased the dividend for at least 10 consecutive years. A quality dividend stock may currently have a lower yield than a high quality bond, but the effect of a rising dividend payout will increase both the income stream and the stock price.
Include taxes when comparing the yields on bonds and stocks. Interest from government and corporate bonds will be taxed at your marginal bracket rate. Municipal bonds pay tax-free interest and will usually have lower yields than taxable bonds. Dividends from stocks of corporations usually qualify for a lower tax rate than your regular income, topping out at a 15 percent tax tax. Calculate the after tax yield for your situation when comparing the yields for bonds and dividend stocks.
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