If you are considering investing probably for retirement, you may have thought of these two bonds and dividend stocks. This is because they are the most common forms of retirement income. However, deciding which one to go for maybe a daunting task.
Knowing what each of them entails regarding the risks involved, investment period, frequency of payments, and preferable type of income will help you make an informed decision. However, there are also some significant essential differences that you need to consider before settling on any, even though they both will earn you some income in your golden years.
The following factors are also to be considered when making an investment decision.
This guide will help make your decision-making process easy by looking at these vital differences between the two classes of assets.
A bond is an investment instrument, and a dividend is an income arising from property ownership or stock. According to JPMorgan Asset Management, the total global bond market by the end of 2017 was about $110 trillion. It is, therefore, one of the largest and oldest classes of assets.
There are several forms of bonds that you can invest in, including;
In this case, as an investor, you will settle for either of the two depending on the level of risk you are willing to bear. Risk takers tend to invest in high-yield coupon bonds. In contrast, risk-averse individuals would prefer investment-grade coupon bonds.
Municipal bonds are issued by counties, states, cities, and other government entities. The bonds have tax benefits where the bondholders will be exempted from paying both the state and the local taxes from their interest incomes. They are available in short and long-term bonds with short-term repaying in one to three years and long-term bonds repaying the principal in over ten years.
Below are things that an investor needs to know about bonds.
The creditworthiness of the Bond Issuer
In terms of safety of investment, U.S Treasury bonds are considered the safest. Municipal or local government bonds are the following safe, then lastly, corporate bonds. For this reason, treasury bonds will have a lower interest rate because there is a reduced risk of the federal government defaulting payments. On the other hand, there are higher chances of a company defaulting payments. For this reason, such bonds will offer a higher interest rate to attract investors, generally for bonds, the higher the interest rate, the higher the risk of defaulting payment by the issuer.
The Bond Term
How long you are going to hold on to the bond matters a lot. Bonds generally have a fixed maturity period of up to 30 years. Still, there is an option of selling them in the secondary market before the maturity date. However, in this arrangement, you run the risk of not recovering your initial investment or principal.
To diversify your portfolio, you may consider joining other investors in buying a bond fund. However, this arrangement is risky, especially because bond funds do not have a fixed interest rate; hence the funds are more volatile. As an investor, you need to analyze different investment arrangements critically and their risks before settling for any. It would be best if you also chose an appropriate bond term that will be suitable for you.
Once the interest rate of a bond rises, the bond loses its market value. This is because the coupon rates of the new bonds in the market will also rise along with the rising interest rates. As a result, the resale value of old bonds in the market will be reduced as more investors will be attracted to the new bonds.
It is possible to resell your bond even before the maturity date. For example, suppose you don't want to hold onto your bond until its maturity date. In that case, there is an option of reselling it in a secondary market. To profit from the resell, you need to consider selling it at a lower interest rate than the one you bought the bond initially. Selling at higher interest rates will result in a loss.
Position in the Company or Government
A bond is created when you loan a government or a corporation. For this reason, a bondholder is a creditor of the corporation.
Bonds are fixed-rate security, meaning they earn income at a fixed interest rate referred to as a coupon rate. As an investor, during the period on the investor, you will receive frequent fixed interest payments. Whether the corporation makes profits or losses, bondholders must pay at the fixed coupon rate. The company’s profitability does not affect the investor's income receivable.
Maturity and Payment
Bonds have a maturity date which is the due date for payment of incomes, and the period referred to as the bond term. Interests are mainly paid annually, and in some cases, semi-annually, like in the United States.
Rate of Return
Generally, bonds will always hold their original value without fluctuating. For this reason, the risk involved is very minimal compared to dividends stocks whose markets are prone to fluctuations. The rate of return for bonds is, therefore, lower than that of dividend stocks.
Level of Risk
The level of risk associated with investing in bonds is much lower. Therefore if you are a risk-averse person, you may consider this for your investment. This is because even though bond markets may fluctuate due to forces of demand and supply, the level of fluctuation is not like that of the dividend stocks.
Priority of Repayment
In the event of winding up or liquidation, creditors are typically paid first. Since bondholders are the company's creditors, they will be paid first out of the available income before the owners. This is an advantage to bondholders as they will be sure of receiving their entire initial investment even before others are paid.
The bondholder's income growth usually is zero. This is because bonds earn a fixed interest rate known as the coupon rate. A fixed rate means zero chance for income growth as the resultant incomes will be fixed through the bond term. There is no inflation protection with fixed-rate bonds. Long terms interest rates will rise with increased expectations in an inflation rise. For this reason, bondholders will expect a higher bond yield in compensation for the higher inflation expectations.
Price volatility relates to the fluctuation in prices and, in this case of instruments of investment. Like the stock market, the bond market is prone to price fluctuations. Still, the price volatility can be categorized as low to medium. This is because the flux of bond prices is not so frequent, and sometimes the bond market is said to be stable.
Fluctuating prices mean fluctuating interests of the bond, and as an investor, you need to consider this. They have a higher rate of interest sensitivity because their coupon rate is usually fixed. For this reason, they are less volatile than stocks.
Bonds have a relatively lower yield than dividend stock. The lower fixed returns are a result of the lower investment risk they carry.
Position in the Capital Stack
This is the most critical difference between bonds and dividend stocks. The two investment instruments differ in their position in the capital, which comprises the total money invested in the business. The company's capital stack may include common, preference equity, and debt.
The organization's capital stack and bonds are the eldest, meaning they are the first obligations to be paid out. Therefore, the total return and the risk profile differ according to the level in the capital stack.
They relate to investors owning property in a company where they are paid dividends or distributions. They represent partial ownership of the company’s property which refers mainly to buying one or more shares in a company.
The stock may include:
Position in the Corporation
Buying the company’s stock makes the stockholder an owner of the company. Your level of ownership will be determined by the amount of stock you hold in the company. As an owner, the company's success is your success, and the failures also your failure. As an owner, you are allowed to influence the decisions of the company through voting at meetings.
Income earned from ownership is a fluctuating rate. This because income or dividends are paid out of the company's income. Investors will only receive income when the company earns profitability. Suppose during a specific period, the company did not make profits or maybe suffered losses. In that case, investors will not receive dividend income. It is illegal for any company to pay distributions out of capital.
Maturity and Payment
Stocks do not have a maturity date as you can own stocks in a company for as long as the company exists. The income from stocks that is dividend is paid as long as the company's management has declared dividends. The dividends will only be declared if the company has earned some income or profits. Payment of income may be semi-annually or annually.
Rate of Return
Because of the high risks involved in investing in stocks, they have a higher rate of return than bonds. The stock market is constantly fluctuating hence the fluctuating the dividend stock, which in turn fluctuates the income from stocks.
Level of Risk
Investing in corporations by purchasing their stock is a precarious form of investment. The stock market is very susceptible to fluctuations which render the investment very risky. There is also the profitability rather than the company's performance because you can only earn income from your investment if the company makes profits.
Another risk results from the performance of the company. If the company performs well, then the value of its stock in the stock market will increase. Conversely, if the company performs poorly, there is a consequent fall in its stock value in the market. This will automatically have a loss effect on the investor.
This form of investment is only suitable for risk-takers and not risk-averse investors. Therefore, it is advisable only to consider investing in what you may be willing to lose.
Priority of Repayment
Stockholders being owners of the company, will always be paid after creditors, in this case, the bondholders, when a company is in liquidation. However, this is a disadvantage to the stockholders because, in some cases, they may not be paid their initial investment in full, especially when the company in liquidation has not realized enough from the sale of its assets to settle all its liabilities.
Dividend stocks typically have medium to fast income growth. However, the investor's income will often increase instead of growing in the case of stocks. This is because the dividend payment is not fixed and may increase depending on the company's profitability.
In increased income, the company may allow its shareholders to participate in the extra profits by declaring higher dividend payments. Dividend growth is usually faster than inflation hence inflation protection.
When the company makes losses or reduces profits, the investors' dividend payment will also change accordingly.
Dividend stocks are highly volatile because they are not fixed. This means that the dividends will often fluctuate depending on several factors such as the company's profitability, the company's dividend policy, and the stock prices at the stock market. For this reason, investors may be discouraged from investing in buying company stocks.
The dividend yield of a stock is much higher than bond interests. However, this yield can be classified as low to high, and this is because of the higher risks involved.
Position in the Capital Stack
Dividend stocks have a junior position in the organization's capital stack. For this reason, they are paid out after other obligations like the bonds are paid. If this is a risk of losing your investment upon liquidation, you may consider investing in bonds.
Choosing the most suitable form of investment is not an easy task. When faced with a selection challenge, the most important thing to do is consider your available options. After looking at your options, you need to be acquainted with all the relevant information about the investment option.
This information will guide you in your decision-making process hence making it easier for you. Consider the differences among these investment instruments and, based on this decision, make a choice. Your choice should match your characteristics like your level of risk tolerance, health, current portfolio, and other factors aforementioned.