Wednesday 21 September 2011

Are Dividend Shares Better Than Bonds/Gilts?

Some investors in high-yield share portfolios ('HYPers') won't look at bonds or other fixed-return investments. Is that rational? Here at the DIY Income Investor we like a mix - Level 5 (Gilts), Level 6 (HYP) and Level 7 (Commercial Bond) on the Income Pyramid.

Who is right? Should you put your money on the fixed-return hare or the dividend tortiose  to win?

As a recent Motley Fool article has put it: "There is no Golden Law of Investing stating that equities always outperform bonds even over a lifetime of investing."
Most income-producing investments can be valued based on their future incomes. The standard way to measure this is 'yield' - the ratio of (annual) income divided by price.

The FTSE 100 forward dividend yield  is currently at 3.8% and 10-year Gilts are yielding a fixed 2.2%, so blue-chip shares are likely to produce much greater income than these government bonds over the next decade (returns on corporate bonds are much higher).

However, as a recent Motley Fool article has underlined, shares are much riskier than bonds.
  • bonds are fixed-income securities issued by governments, companies and other organisations, paying a fixed yearly interest rate (known as a coupon), plus they return your money in full when they mature. As bond owners are creditors of a company, they are near the front of the queue when a company becomes insolvent. Government bonds (for most countries) are as close to risk-free as you can get
  • shares are a (small) part-ownership of a company, this ownership doesn't give them too many rights, apart from voting at company's annual general meeting (yawn...); although shareholders may receive dividends from the company (usually two or four times a year), these cash payouts are by no means certain. What's more, when companies get into financial difficulty, shareholders are right at the back of the queue.

Until the Fifties, there was a 'yield gap' between higher-yielding shares and lower-yielding Gilts (UK government bonds). In other words, the variable dividends paid by shares provided a greater yield than the fixed income paid by government bonds, indicating that the more certain income from Gilts was valued highly.

Currently, there is in the UK a positive yield gap, where shares yield considerably more than government bonds. In fact, "it's not so much a yield gap as a 'yield gulf or yield abyss" to quote Motley Fool.

A recent Motley Fool article has identified that over the longest periods, the returns from shares have comfortably beaten those from bonds, according to the Barclays Equity-Gilt Study:
  • shares produced an average 'real' return (after inflation) of 5.4% a year from 1960 to 2010
  • Gilts (UK government bonds) returned a mere 2.5% a year over the same timescale

But this pattern is by no means universal or constant. In fact, there have been lengthy periods in modern history when bonds beat shares. For example, between 1968 and 2008, US Treasury bonds produced higher real returns than US equities. This has happened in other major nations, too. In an analysis entitled Long-term Asset Return Study: A Roadmap for the Grey Age, top analyst Jim Reid of Deutsche Bank found other examples of long-term underperformance by shares. Reid found that, since 1962, bonds have beaten shares in three leading economies: Germany, Italy and Japan.

However, the conclusion of this study is not straightforward: "Buy and hold is probably not the optimal strategy over the next few years. Trading around the more frequent business cycles will likely be crucial. For those preferring a buy and hold approach, the accumulation of a diversified portfolio of equities where their dividend exceeds their bond yield will probably be very successful over the medium to long-term." They give a list of 110 suitable candidates companies.

So, if you are going to buy a high-dividend share you should probably check whether the same company offers a bond with a (much) higher yield - both run the risk of business failure.

However, I took the view in previous post that a reasonably safe but fixed high yield now is better than a lower dividend yield that might grow in the future.  So I will stick with a proportion of fixed-income securities in my portfolio. A combination of hares and tortioses, if you like.

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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