Wednesday, March 15, 2023

Stocks Versus Bonds Today

I wanted to present some general discussion about fixed income securities. I will then present the companies I invested in this week, followed by a detailed review of each at the end of the newsletter. I included this commentary in the March 2023 Dividend Growth Investor Newsletter. I originally used Treasury Bills, but edited to Certificates of Deposit here.

For the past 15 years, we’ve had falling or low interest rates in the US. The last time I could buy a Certificate of Deposit (CD) yielding 5% was in 2008. Today, after 15 years, I could buy a Certificate of Deposit yielding 5%. I could theoretically lock money for up to 2 years at 5%/year using a Certificated of Deposit.

Naturally, I see some investors gravitating towards fixed income.

I see nothing wrong with owning some fixed income instruments, especially for short-term savings needs such as having your emergency fund, or saving for a major purchase within the next say 1 - 2 or 3 years. It may make sense for some older investors as well, especially if they have lower risk tolerance.

With Bonds, you are guaranteed to get your original principal back and you are guaranteed to earn your interest as well. We are going to assume you hold through the maturity date. Otherwise, you may end up losing money under some scenarios (if interest rates increase after you buy the bond). You may also end up making money if you sell early (if interest rates decrease after you buy the bond).

However, the downside of fixed income instruments is that they are fixed in terms of yield and term. This means that at the end of your term (when the bond expires), you would have to acquire another bond. However, we do not know today if those yields would be higher or lower.  In addition, your return is limited to the interest rate you settled on at the time of purchasing that bond. It would never increase, though you are guaranteed to get your principal back at maturity.

The other risk is that these fixed income instruments offer high nominal yields, but that doesn’t really tell you much about the real yields after inflation. A bond yielding 5% sounds nice, but is not as cool if inflation is more than 5%. In that case, you are losing real purchasing power for your principal AND income.

A third issue is that interest income on bonds is full taxable at ordinary tax rates. Treasury Bonds are exempt from state income taxes, though interest on CD’s is taxable at the State and Federal level. That could be avoided by buying them through a retirement account.

The fourth issue is reinvestment risk. One can buy a 1 year or 2-year Certificate of Deposit yielding 5% today. They are guaranteed that rate for the duration of the bond. At maturity however, they have to reinvest at the going rate. That rate could be higher or lower. Over the next decade, that’s several reinvestment risk scenarios out there. There is not a high likelihood that Short-term Bond would generate 5% annualized returns over the next decade. Investors could theoretically buy a 10 year Bond yielding 4%. However, the issue is that their coupon would not increase. In addition, the purchasing power of their principal and income would slowly lose value over time.

 

With dividend growth stocks, you may be getting a lower yield today, but there is a decent chance that over a longer period of time that dividend income will grow at or above the rate of inflation. This helps preserve and even increase purchasing power of that passive income. In addition, there is the opportunity to generate capital gains as well, as those businesses earn more money and distribute more to shareholders over time. Of course, nothing is guaranteed and there is risk, but if history is any guide, it is possible that a diversified portfolio of dividend growth stocks would be generating a higher income in 10 or 20 or 30 years from, while also being valued at higher prices over that same time period. Purchasing A bond that yields 4% that expires in a decade would yield income that doesn’t grow and a value that doesn’t change at maturity.

In addition, I wanted to share a longer-term view of total returns on US Equities, Bonds and Short-term bills between 1926 and 2022:



Source: https://www.newyorklifeinvestments.com/assets/documents/education/investing-essentials-growthofadollar.pdf

I believe that a long-term investor in equities over the next 10 – 20 - 30 years would do better than an investor in fixed income like T-Bills or Certificates of Deposit. A diversified dividend growth portfolio would likely generate much higher future yields on cost and total returns over the next 10 - 20 - 30 years. A bond portfolio would not.

I understand the logic to hold fixed income for items such as an emergency fund, or if someone is saving for a particular large expense over the next 1 – 3 years for example. In that case, using bonds or a savings account seem like a good idea. However, I would discourage folks who are buying Treasury Bills or Certificates of Deposit in an attempt to try and to time the market.

"The Secret Sauce

 In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire. 

The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow. 

American Express is much the same story. Berkshire’s purchases of Amex were essentially completed in 1995 and, coincidentally, also cost $1.3 billion. Annual dividends received from this investment have grown from $41 million to $302 million. Those checks, too, seem highly likely to increase. 

These dividend gains, though pleasing, are far from spectacular. But they bring with them important gains in stock prices. At yearend, our Coke investment was valued at $25 billion while Amex was recorded at $22 billion. Each holding now accounts for roughly 5% of Berkshire’s net worth, akin to its weighting long ago. 

Assume, for a moment, I had made a similarly-sized investment mistake in the 1990s, one that flat-lined and simply retained its $1.3 billion value in 2022. (An example would be a high-grade 30-year bond.) That disappointing investment would now represent an insignificant 0.3% of Berkshire’s net worth and would be delivering to us an unchanged $80 million or so of annual income. 

The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. And, yes, it helps to start early and live into your 90s as well."

 I believe what Buffett is trying to tells us is that for a long-term investor, the best bet is US Equities over Bonds. That's because equities would increase purchasing power for net worth and income over time. Fixed income instruments like Bonds or Treasury Bills or Certificates of Deposit are good places to park short-term cash. That in my opinion is cash that is needed in the next 1 - 2 - 3 years. 

Relevant Articles:


- Does Fixed Income Allocation Make Sense for Dividend Investors Today?





at

Popular Posts