Financial wisdom holds that bonds make excellent investments for income oriented investors. Bonds tend to offer a higher interest payment than common stock dividend payments. Compare McDonald’s (MCD) long-term debt to its common stock.
McDonald’s medium-term debt (matures around 2040) has a yield to maturity of just under 4.50%. It’s common stock has a dividend yield of 3.25%. Investors in McDonald’s debt would get income about 40% higher than common shareholders on day 1.
Investing is not all about day 1, however. Holders of common stock own a small portion of the company. Debt holders only own the debt of the business. As McDonald’s grows, investors who own common stock take part in that growth. All things being equal, the stock price will rise as the company grows.
It is very important to note that just because the company grows, this does not mean dividends will increase. With bonds, you get a guaranteed payment amount (more on that later). With common stock, there is no guarantee the dividend will continue or increase with overall company growth.
Don’t Trust Corporate Words, Trust Corporate History
Some publicly traded businesses have a long history of increasing dividends each and every year. These businesses are known as Dividend Aristocrats. They are companies with 25 or more years of consecutive dividend increases. You can find a complete list of all 54 Dividend Aristocrats here.
The dividend payments of Dividend Aristocrats are not guaranteed. They are extremely likely to continue, however. Over the last 3 years, less than 3% (per year, on average) of stocks with 25+ years of increasing dividend payments did not increase their dividend payments. Dividend history really does matter.
Just because a company says it will pay a dividend does not mean it will. When a company has a very long history of dividend increases, it is very likely the company will continue to pay increasing dividends. Invest in stocks that don’t just talk the talk, they walk the walk.
Back to McDonald’s
Let’s look at McDonald’s again and take a trip back in time to 2004. It was an interesting time. George Bush was President, Lance Armstrong won his 6th consecutive Tour de France, and Yeah! By Lil John & Ludicrous was number 1 on the billboards.
McDonald’s paid out $0.40 per share a year in dividends in 2003. Shares were trading for about $25 at the start of 2004, giving the company a yield of 1.6%.
Fast forward back to today. McDonald’s is paying $0.81 per share… every quarter. The current yield on cost for those who purchased McDonald’s 10 years ago is 13.07%… About 3x what McDonald’s bonds pay today.
The biggest advantage bonds have over stocks is guaranteed payments. Even legal guarantees are only as good as the earnings power and assets of a company. If McDonald’s announced they were selling only tofu tomorrow, the company would go bankrupt in a hurry (in my esteemed analysis).
Bond holders would NOT receive all the interest payments that are guaranteed because there would be no money to pay them. McDonald’s assets would be sold, and the cash would go to paying bondholders. If these funds were not sufficient to cover the outstanding debt, then bondholders would be left without a full repayment.
Holders of Dividend Aristocrat common stocks do not have a guarantee they will receive a dividend payment each year or quarter. What they do have is a very high probability of getting increasing payments. There is no legal guarantee, but there is a strong historical precedence of payments that is unlikely to be broken if the business is in good health.
If a business is in decline, bondholders will receive payments for a time, while holders of common stock will not. If the business goes belly up, then there is a high probability bondholders will incur a significant loss of principal.
Both stock and bond holders bet on the future of a company. Only common stock holders receive compensation for growth of the business in which they invest.
35 Year Bond Bull Market
The last 35 years have been VERY kind to bond holders. Interest rates have continuously declined over the last three and a half decades, causing bond prices to rise. Bond prices rise as interest rates fall because the future bond payments become more valuable the lower interest rates are.
Interest rates cannot fall forever. Purchasing medium and long-term bonds is placing a bet on what interest rates will do. When a financial instrument starts breaking multi-decade records, it is time to stop and think.
– Jim Rogers, co-founder of Quantum Fund
The massive bond bull market has been fueled by slashing of interest rates by the Federal Reserve to stimulate the economy through cheap credit. This cannot continue indefinitely. The European Union Central Bank recently announced negative interest rates. They have gone one-step beyond the US Federal Reserve’s 0% Federal Funds rate… Negative interest rates are counterintuitive. The European Union is saying money tomorrow is worth more than money today. This violates the “1 in the hand is worth 2 in the Bush” axiom that has served society well since antiquity.
Dividend Aristocrats & Current Yield
McDonald’s has admittedly had a fantastic 10 year run, but there are other Dividend Aristocrats from 2004 that have a high yield on cost now. The top 10 2004 Dividend Aristocrats based on yield on cost are below:
Time & Money
Investing in high quality businesses with a long history of dividend growth is an excellent way to compound wealth and generate income over time. Bonds are a better investment if you must have every last bit of income today. If time is on your side and you can live with a lower income today to generate more income tomorrow then high quality dividend growth stocks are your preferred investment.