For the first time in years, government bonds are delivering the same yields as some of the best dividend stocks.
Which has people wondering – which should I own? Dividend stocks or government bonds?
It’s a valid question.
Getting this important question wrong is more costly than you might think.
Stocks in general, even high-quality dividend stocks, are much more volatile than government bonds.
That’s because bond prices aren’t affected directly by the day-to-day prices of the stock market.
But government bonds aren’t as insulated from outside forces as you might think. They’re affected by interest rates… in a big way…
So which one is better for your portfolio right now?
Today, we will walk through what happens to both dividend stocks and government bonds when interest rates go up and down in response to rampant inflation. So read on and decide for yourself, which one is better for your portfolio.
The Banking Crisis of 2023 Was a Learning Lesson
First, to set the stage, let’s look back to a recent event that played out at the beginning of this year.
I expect it’ll come to be known as the “Banking Crisis of 2023.”
We lost Silicon Valley Bank (SVB), Signature Bank (SBNY), and First Republic Bank (FRC), which was bought by JPMorgan.
All these banks had one thing in common…
They heavily invested depositors’ money into government bonds. And what did the Federal Reserve start doing in 2022 that impacted the value of these bonds?
It raised interest rates. In fact, it started raising them at the fastest pace ever.
And when interest rates rise, bond prices fall.
So when Silicon Valley had a run on the bank with members pulling out their money in a panic… Instead of having it readily available, the bank had to cash out its government bonds… at a big loss.
Silicon Valley had to sell its $21 billion bond portfolio to meet demand from depositors. And thanks to the rise in interest rates, that desperate sale resulted in an $1.8 billion loss.
Suddenly, multiple banks were sitting on an enormous amounts of unrealized losses. And people all over the country started trying to pull their money out.
Now why am I telling you this story?
Because it’s a learning lesson. The Federal Reserve has made it clear it’s not done raising interest rates yet.
So whatever Treasury bonds you buy in the near future – they’ll be directly affected.
To calculate just by how much… Let’s walk through the math.
What Happens to Bonds vs. Stocks When Interest Rates Go Up
Right now, a 10-year Treasury bond yields around 5%.
That’s more income than you can get from classic dividend stocks like Coca-Cola (KO) or McDonald’s (MCD).
But to make an accurate comparison, we need a dividend stock with the same annual yield as the 10-year Treasury bond.
So today, I’ll use one of my favorite dividend stocks, Royal Bank of Canada (RY).
While it’s not as safe as a Treasury bond, Royal Bank of Canada has paid stable dividends for well over a century. That’s a longer time frame than many governments have been around.
To see how a stock like Royal Bank of Canada stacks up to a 10-year Treasury bond, we need to understand what happens when interest rates go up and down.
Let’s start with up… Just like today, higher rates are almost always a direct response to combat higher inflation.
A 2.5% increase in interest rates makes the Treasury bond fall by 18%.
That’s math, not speculation. It’s a problem, but not the biggest.
If inflation keeps climbing, purchasing power keeps falling. Your dollar won’t go as far as it did.
And as inflation climbs, new Treasury bonds are offered at higher yields.
So why don’t you just sell your 5% yielding 10-year Treasury bond and buy the new 7.5% 10-year Treasury bond?
Because by selling it, you’ll officially have lost 18% of your investment. That makes switching to the new, higher-yielding bond a wash.
Now, let’s see how Royal Bank of Canada does when interest rates go up by 2.5%.
Royal Bank of Canada paid $0.763 in quarterly dividends when the pandemic spending kicked off in mid-2020.
It’ll pay a $0.984 dividend next month. That’s 29% growth.
So Royal Bank of Canada’s dividend payments typically rise with inflation and higher interest rates, while 10-year Treasury bonds pay the same and decrease in value.
It’s times like these that holding a reliable dividend stock makes more sense.
But what if rates go down?
What Happens to Bonds vs. Stocks When Interest Rates Go Down
If interest rates go down 2.5%, the 10-year Treasury bond will increase in value by 22%.
But the problem is, even though you can technically sell for a profit, you won’t. Because once you do, every option pays a low yield.
In this example, Treasury bonds would only pay 2.5%. Reinvesting the profits still nets you 40% lower income than our original Treasury bond. So while the paper gain looks great in your brokerage account, odds are you’ll never realize that gain over the long term.
What about Royal Bank of Canada?
Just like today, it usually trades with the same yield as the 10-year Treasury bond.
If interest rates fall, Royal Bank of Canada’s share price will move higher. That’s because if the Treasury bond only yields 2.5%, people will still buy Royal Bank of Canada stock as long as it’s a little above that.
In our previous example where the bond gained 22%, Royal Bank of Canada would be worth $130.66 per share using today’s dividend rate.
That’s 61.4% higher than Friday’s close.
And Royal Bank of Canada comes out the winner once again.
In fact, stocks or equities beat bonds by at least 77% during inflationary periods over the last 146 years, as you can see below.
Source: Robeco
Best of all, Royal Bank of Canada will likely keep raising its dividend as it has for decades. And dividend stocks do better than non-dividend paying stocks.
Dividend stocks are one of the best asset classes to fight inflation. This chart shows all periods since 1975 when inflation was above average.
Now that we have all the information, I think the answer for what you should be buying right now is pretty clear…
The Answer: Dividend Stocks
While a 5% bond backed by the full faith and credit of the U.S. government has its appeal… If interest rates go up or down, the plan falls apart.
And there’s a high chance we’ll see that happen in the next few months.
Stocks beat bonds long-term every time. And higher-quality dividend stocks, like the kind we focus on at Wide Moat Research, do even better.
Best regards,
Stephen Hester
Analyst, Intelligent Income Daily
Source: Wide Moat Research