Dividend Stocks Versus Bonds for Retirement Income

Savers rejoice! Yields of 4% to 5% are now available across fixed income securities such as Treasuries, corporate debt, certificates of deposit, and high-yield savings accounts.

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:

Let's start with a brief overview of each asset class.

Bonds are the one of the oldest and largest asset classes. Corporations and governments issue bonds to investors in exchange for cash they can use to run their organizations.

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:

Some of the most important metrics for bond investors to know are:

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).

Dividend stocks represent companies that pay dividends or distributions to investors who own a part of the business.

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.

A number of major differences exist between bonds and dividend stocks:

The most important distinctions between stocks and bonds are due to their respective positions in the capital stack, which is comprised of the total capital invested in a business.

Capital stacks can include common equity, preferred equity, mezzanine debt, and senior debt. Each level possesses its own risk and return profile.

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. 

Bonds usually have low default rates, especially for bonds issued by stable, developed governments and corporations with investment-grade credit ratings (BBB- or above).

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.

As lower-risk income investments, bonds tend to offer lower yields and returns than many dividend stocks.

On the plus side, bonds tend to be less volatile than stocks since their return is driven by fixed interest payments rather than capital appreciation.

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.

While bonds usually experience lower volatility than stocks, their sensitivity to changing interest rates can result in bouts of turbulence as 2022 demonstrated.

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.

The interest rate sensitivity of bond prices depends on what's called the "duration" of the bond. Duration is mostly a factor of how long the bond has left to maturity. 

The longer the duration of a bond, the more its price can fall as interest rates rise, all else equal.

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.

Even before yields shot up, most retirement portfolios owned at least some bonds for the diversification benefits they provide.

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?

Let's suppose you...

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.

Dividend stocks provide a critical complement to bonds: income growth.

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.

Higher bond yields have made fixed income securities interesting again. But on their own, bonds continue to look insufficient to fight inflation and fund a long retirement for most investors.

Dividend stocks can provide a powerful foundation for generating reliable income with good potential to outpace inflation, a quality bonds will never have.

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