I’ve pitted bonds against dividends a lot in the past few weeks. Let’s hit on reinvestment risk as you hunt for stability while major indexes rise and fall.
I’m not the biggest fan of bonds.
Sure, they have their place. If you’re in or near retirement, it’s hard not to allocate at least a portion of your portfolio to bonds.
But for income production, bonds have major shortcomings.
As I recently shared with my friend and research analyst, Matt Clark, a good basket of dividend stocks is a superior source of income over your lifetime as an investor.
Stock dividends for healthy, growing companies tend to rise over time. That means larger payouts the longer you own.
But fixed income is fixed. It’s in the name. Unless you own special inflation-adjusted bonds (which aren’t common), the interest payments thrown off the investment will be the same years from now as they are today.
Bond risks go beyond that.
Reinvestment Risk Explained
Think of stocks as a perpetual asset. A company can theoretically live forever, so if you choose well, you can hold a stock for the rest of your life.
I own shares of blue-chip retail REIT Realty Income (NYSE: O) that I will never sell. My children will inherit them someday, and the shares will be theirs to do with what they will.
But bonds mature. If you buy a 10-year bond when it’s issued, you’re getting your money returned to you in 10 years, whether you want it or not.
This introduces reinvestment risk.
Let’s say that, inflation and all, you’re happy collecting your 3% coupon on your 10-year Treasury. Well, once the bond matures in 10 years, you might be facing a very different investment landscape. Yields might be significantly lower or higher — we don’t know.
Looking back might help paint this picture.
Bond Investors Had It Made in the 1980s
Let’s say you bought a 10-year Treasury note at par in 1981. You would have collected 15% annual coupon payments for the next 10 years. Not bad!
But when the bond matured in 1991, your investment options didn’t look as good. By 1991, the 10-Year yield had fallen to about 8%. Your income stream was chopped in half if you had depended on those 15% coupon payments to pay your bills.
Now, few bond investors would have experienced a jarring change like that. Most bond investors use diversified bond funds or laddered bond portfolios spread across several bonds of varying maturities.
But even in that case, it would’ve been death by 1,000 cuts. As each bond in the portfolio was replaced with a lower-yielding bond, the investor’s income stream would get lower year after year.
The 1980s and 1990s were a special time when yields fell from historic highs to historic lows. We probably won’t see something that extreme ever again.
Then again … we might.
Even if history doesn’t repeat, it’s not like we are living in a world of bond yields that can’t be ignored. It’s been more than decade since the 10-year Treasury yielded more than 3% on a consistent basis. We can find companies with similar payouts that also sport healthy stock growth.
Dividend Reinvestment Risk
I know dividend-paying companies aren’t immune to these same pressures.
Dividend stocks also have a reinvestment risk of sorts, in that yields may fall over time. If you sell a high-yielding stock, the one you replace it with might have a lower payout.
But that’s just it: No one says you have to sell. Ten years down the road, the SEC isn’t banging on your door demanding you sell all your O stock and reinvest it.
If you have a good portfolio of dividend workhorses raising payouts every year, you can avoid reinvestment risk by letting your winners run.
To safe profits,
Charles Sizemore, Co-Editor, Green Zone Fortunes
Charles Sizemore is the co-editor of Green Zone Fortunes and specializes in income and retirement topics. He is also a frequent guest on CNBC, Bloomberg and Fox Business.