I just love bonds, but, as I said in my last post, I can't recommend them right now. Well, that's not strictly true; it's just that I can't recommend my favorite investing technique, which involves the regular purchase of BAA 30-year bonds. Yields are simply too low; rising rates will trash principal if you buy at today's inflated prices.
So, what should you do? In the frantic hunt for yield, the flavor of the month is the high-dividend stock, particularly one with rising dividends. Do the math, say the gurus: even a stock with a moderate dividend will beat bonds handily if that dividend grows over time. They spin lovely scenarios like this: a company with a 3% dividend increases that dividend steadily over a ten-year period, say at a rate of 5% annually. So, a $100 stock will initially yield $3. After ten years of growing at a 5% rate, that $3 becomes nearly $5. Assuming the price/earnings ratio stays the same, that $100 stock is now worth $166! Add in the cumulative dividends (say $40), and you've doubled your money! Factor in the favorable tax treatment (15%) given to dividends, and you've beaten bonds to death! Lovely, right?
As I've pointed out before, there serious problems with the scenario. They derive, in the main, from the fact that dividends and interest are very different things. In the broadest sense, both are sluices from a larger income stream. What is the larger stream? Well, it's the money a company generates by doing what it does: lending money, selling automobiles, refining copper, brewing up syrup-laden lattes, etc. Interest is one of the company's core expenses whereas dividends are diverted from the income stream after expenses are paid. Logically, therefore, interest comes first and dividends trail, badly.
If a company's expenses rise more rapidly than its ability to increase sales or raise prices, then the viability of the dividend is jeopardized. THAT, folks, is exactly what happens, over and over and over. A company will establish a very nice record of paying steadily rising dividends, only to cut them severely, or even eliminate them, when tough times arrive. This isn't a rarity; it's predictable. Yes, recessions do damage a company's cash flow, and perhaps its ability to pay the dividend. But they are also a great excuse for cutting back on an obligation that will become unsustainable in the future. That is partly why dividends were pared so savagely in 2008/9 and 2001/2. In fact, EVERY recession brings waves of dividend cuts. You can count on them, and they absolutely trash the lovely scenario painted above. The haircut is twofold: you get less income, and the stock price drops to account for the diminished payout. It can take years to recover.
Instead of running off after yield alternatives, my advice is to be patient. If you're lucky enough to be receiving regular interest payments from a Bodacious portfolio, you can just sit on the money for awhile. To that money you can add redemptions (remember, you've laddered BAA bonds over a 30-year spectrum). Cash and cash equivalents will build steadily.
You will probably be surprised how rapidly today's low-interest environment will fade. Until then, I suggest you stick with bonds: just of a different type. If you look for investment grade bonds with a 1-2 year maturity, you'll discover that it's perfectly feasible to capture yields in the 2.5% to 3% range. That's generous enough to pay your taxes and cover today's inflation as well. Yeah, you're not gonna get ahead, but you're not falling behind either. Sometimes, staying even is a very good thing, all by itself. As bond income and redemption cash comes in, you can ladder your purchases, buying 1-2 years out, two or three times a year.
Then, you wait, like a spider. Eventually, rates will rise. Eventually, they will rise enough to let you go out on the maturity spectrum, and capture yields that will beat inflation and taxes, and still leave you a generous return. If you get to one of those rare moments when yields have soared, and prices plunged, then you can go for the long bomb: using leverage to lock in cyclically peak yields.
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