Interest rates in the United States of America have been on a decline for over 40 years.
Source: J.P. Morgan Guide to Markets
Over the past 10 – 15 years however, rates have practically reached very low levels. While it was possible to earn 4% - 5% from a short-term Certificate of Deposit or a Savings account before, today rates are more pitiful.
Source: J.P. Morgan Guide to Markets
In addition, rates on long-term US Treasury Bonds, particularly the 10 and the 30 year ones have been decreasing as well. Interest coupons are correlated with returns on bonds. Therefore, if you invest in a 30 year US Treasury bond yielding 2.10% today that you hold for 30 years, you are unlikely to generate more than 2.10%/year. This means that on a $100,000 investment, you are unlikely to generate more than $2,100/year in interest income.
Source: Bloomberg
This income is taxed at ordinary tax income rates, and is fixed. It won’t grow to compensate for the loss of purchasing power due to inflation. Treasury Inflation Protection Bonds and iBonds exist, but these don’t yield much. They will likely protect principal at most.
Of course, US bond investors are lucky. The rest of the developed world has long-term bonds which yield practically nothing.
Source: J.P. Morgan Guide to Markets
If you are a saver, the only alternative you have to generate income, and protect principal against inflation is in equities. This means that investors have to take on risk in order to generate an adequate return.
Some may argue that this risk on environment has pushed valuations higher, and therefore future returns lower. It has certainly pushed down yields on US equities, as shown by S&P 500.
Source: Standard and Poor's
Of course, as investors, we take a DIY approach where we select companies individually, based on our own parameters for our strategies. I believe it is possible to build a portfolio today that would yield around 3% today, whose dividend income would outpace inflation in the long-run, and which would likely grow earnings and share prices in the long-term as well.
It is better to generate some return on investment by investing in equities rather than slowly lose purchasing power to inflation by lending money to the US Government.
To illustrate the dilemma, I compared the yields on US Treasury bonds to the average yield on the 63 Dividend Aristocrats ( They removed AT&T at the end of 2021 and also removed Legett & Platt because it was kicked out of S&P 500).
I believe that the 63 Dividend Aristocrats today offer a better alternative for a long-term investor with a 20 or 30 year timeframe than an investment in US Treasury Bonds over the same time period.
Source: Dividend Growth Investor/Standard and Poor's
The average yield on the dividend aristocrats is 2.22% today. The P/E is at 19 today, according to Morningstar, which is not too high. It brings in some margin of safety in case rates revert back to a more normal 4% - 5%.
These companies are likely to grow earnings, dividends and share prices over the next 20 – 30 years easily. If a company yields 2% today, but grows dividends at 7%/year, it could double dividends in roughly a decade. This means that the yield on cost would rise to:
- 4% in 10 years
- 8% in 20 years
- 16% in 30 years
If dividends grow above the rate of inflation over the next 20 years, as they have historically, then the purchasing power of that income will be maintained and even increased. If earnings grow as well, this means that the value of the investment would also maintain purchasing power as well. While stock prices fluctuate in the near term, in the long-run they follow the trend in earnings. Therefore, a patient long-term investors would have a chance of the best of both worlds – generating an inflation adjusted stream of income while also growing purchasing power of their capital as well. To add to that, qualified dividends and long-term capital gains are taxed at preferential rates today. Taxes can be managed of course, by using a retirement account for example. Of course, the risk with Equities is that earnings and dividends do not grow, and share prices do not grow either. Nothing is guaranteed. However, I do believe that taking a risk by investing in equities today is less risky for the long-term investor than not taking a risk at all.
Investors in 30 year US Treasury Bonds are essentially locking in 2.10% for the next 30 years. That coupon will not increase, but is guaranteed by the US Government. However, it is very likely that the purchasing power of that income and the purchasing power of that principal would be much lower in 30 years. Furthermore, this income will be taxed at ordinary income tax rates. However, taxes can be managed too.
What is the point of this article?
It shows me that equities are better investments thant fixed income for someone with a 20 – 30 year horizon. They are likely to generate growth in earnings over time, which would grow dividends and share prices. This would maintain and even increase purchasing power of dividend income and capital invested. This has been the case for the past decade.
While equities may seem expensive at 20 – 24 times earnings, this is equivalent to an earnings yield of 4% to 5%. This is higher than interest yields of 2%. It also provides margin of safety in case interest rates revert back to 4% - 5%, because it shows that P/E multiples on average would not contract by much.
I believe that a prudent investment method would be to invest in dividend growth stocks, such as the Dividend Aristocrats. That’s because these companies have a proven track record of growing dividend income throughout various economic and business conditions. They also have a track record of growing earnings and are likely to grow share prices too. Of course, not all companies on the Dividend Aristocrats list are buys today. The investor would have to evaluate each company in order to determine if:
- They can grow earnings, in order to grow the dividend
- The payout ratio is adequate and dividends are not in danger of a cut
- Valuation is adequate
In order to keep costs low, I would focus on avoiding ETF charges and stock commissions. I would also focus on investing through tax-deferred accounts, in order to keep taxes low. It does pay to be selective however.
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