There are two bonds worth
talking about today: a basic bond, and a special derivative bond. The basic
bond works as you might suspect; it pays a fixed, 2% yield, and in less than
ten years, the bond matures. At that time, you will get back your principal,
unless there's a default. Since this is an investment-grade bond, the chances
of default are low. Even if the market gets pretty tumultuous, you'll receive
your entire principal back. Furthermore, should the bond default, you'll
always get some money back as a creditor in the bankruptcy proceedings.
The really hot bonds on
the market are derivative bonds. They pay a 3% yield, which blows the other
bonds out of the water. However, if the company starts doing poorly, the bond
issuer has the option to pay a lower coupon payment, but there's an upside: If
things are going well, the coupon payments may actually rise.
The yield isn't the only
thing that's variable, though – the principal is as well. With a derivative
bond, your principal isn't guaranteed. It depends on how the market and the
company are doing when it's time to exit the bond. If market conditions are
tough, the bond may repay only 60% or 70% of the principal – or even less. On
top of that, these bonds aren't considered senior secured debt. In the event
of a bankruptcy, you would likely get nothing.
Many pundits out there
are raving about the superiority of derivative bonds. Paying 3% while basic
bonds pay only 2% is a big difference in a low-yield world. But what many
investors don't consider is the dangers of derivative bonds in comparison to basic
bonds:
1. Your principal is not
guaranteed.
2. Your coupon payments
may change.
3. In the event of a
default, you will lose everything.
4. Market conditions can
severely affect the value of your bond.
Sure, your coupon
payments and principal may rise, but they also may not. When examining these
risks, it's easy to see that derivative bonds are a lot riskier than basic
bonds. From that perspective, 3% yield does not seem to properly compensate
one for the possibility of lost principal and coupon payments. Would you
accept all of these risks for that single percentage point? If I were looking
for yield alone, I wouldn't.
Dear reader, I now must
make a confession: There are no bonds like the derivative bonds described
above. I made them up. What I'm describing is a dividend-paying stock. Your
dividends may rise, but they could be cut. Your initial investment may grow,
or it could crash with the market. In the event of a bankruptcy, the
bondholders will be secured, and you'll get nothing.
I have misled you to
demonstrate a point. Many pundits are saying that it's pointless to buy a
bond at 2% when you get yields on dividend-paying stocks yielding 3%. Their
suggestions are a bit disingenuous, because bonds and equities are distinctly
different asset classes. If this were an apples-to-apples comparison, 3%
definitely is better than 2%. However, instead we're comparing apples to
oranges – they're both round fruits, but the similarities don't go much
further. Same goes with bonds and equities – they both pay yields, but their
risks are very different.
Earlier when we pretended
that both were bonds, you could easily see that equities or "derivative
bonds" were a lot more risky than a basic bond. Income investing isn't
simply about comparing yields – the main issue is evaluating risk and yield
together.
Furthermore, the way
dividend-yielding stocks are often advertised ignores the most likely
comparisons in the bond world. A US Treasury paying 2% is not a good
benchmark for a 3% dividend-yielding stock. The risks are nothing alike. If
we were to make a comparison with a bond, it should be to bonds with market
risk. Yes, such a comparison does exist; they're called junk bonds.
If the stock market
tanks, a portfolio of junk bonds will go down with it. Essentially, junk bonds
have market risk very similar to equities. So here's a novel idea: Since junk
bonds and equities have similar risks, why not compare their yields instead
of making a comparison to Treasuries? The junk bond fund JNK currently pays
almost a 7% yield. That crushes the 3% on the dividend-yielding stock –
meaning that the yield on the stock is actually not compensating you for the
risk.
This doesn't mean that
yield-seekers should stay clear of stocks. In fact, our portfolio at Miller's
Money Forever has plenty of dividend-paying stocks. What I'm
suggesting is that you don't compare bonds and equities on yield alone. By
only comparing returns, you're going to get creamed in the market. Your
primary reason for owning a stock should be because it's a good company. If
it happens to have a good yield also, that's a great secondary consideration.
Our Miller's Money
Forever portfolio is directed to baby boomers and retirees who need to
conservatively and consistently grow their nest egg while earning some yield
to supplement their income. The primary consideration is finding good, solid,
safe investments in companies with proven track records. While we are excited
that our six dividend-paying stocks have all increased their yields since our
original purchase, it's even nicer to see capital appreciation on them.
For example, subscribers
who bought our new recommendation in December 2012 have earned a 4% yield on
top of 10% capital appreciation in just three months. Since its August
recommendation, another stock has delivered 20% in capital appreciation on
top of a 3.9% yield. Learn more
about our portfolio and how Miller's Money Forever
can help you grow your nest egg.
