Dividend Stocks vs. Bonds: Are Dividend Stocks a Good Substitute for Bonds?

When choosing to invest, you might consider a wide variety of stock market options. Dividend-paying stocks and bonds might pique your interest — high-yield bonds in particular.

But if you’re after higher yields (which, of course, most investors are after) which option makes more sense for you?

We’ll go over the definition of dividend stocks, bonds, the differences between dividend stocks vs. bonds and whether you should invest in dividend stocks or bonds. Once you’re finished reading, you should be able to decide whether you want to pursue dividend stocks or bonds or stick to ETFs or mutual funds instead.

What Are Dividend Stocks?

Stocks that pay dividends are usually well-established companies that regularly distribute dividends through a distribution of cash or stock to a particular shareholder class in a company. Dividends usually come to investors on a regular basis; preferred stock shareholders receive their dividends before stockholders that own common stock receive theirs. Preferred stock payments tend to be higher.

Once a company declares the dividend amount, all holders of the stock that own it by the ex-dividend date (ex-date) will get paid accordingly on the subsequent payment date. The ex-dividend date for stocks is usually set one business day before the record date. Investors who receive dividends usually receive the dividends as cash or reinvest them in order to accumulate more shares.

If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Your best bet is to purchase before the ex-dividend date in order to get the dividend.

What Are Bonds?

You can think of a bond as a debt security, like an IOU. Put another way, a bond is a loan. Instead of heading to a bank to borrow money, borrowers use bonds to raise money from investors that will lend them money over a specific period of time. As an investor, you agree to receive the face value of the loan by a specific date and in addition, you receive interest payments during that specific period. You can usually expect to receive interest payments about twice per year.

There are several types of entities that offer bonds, including businesses, governments and municipalities.

Corporations a­ren't the only entities that can issue bonds. Governments and municipalities sell them as well. Let’s take a quick look at the definitions of each type:

• Governmen­t bonds: Governments issue bonds for various reasons, including to pay bills. The U.S. government, for example, issues bonds from the treasury and government agencies. There are three major kinds of bonds: T-bills, which mature in less than one year. T-notes mature over the course of one to 10 years, while treasury bonds take more than 10 years to mature.
• Municipal bonds: When they can’t collect the money they need through taxes, states, counties, cities and other municipal entities issue municipal bonds to raise money for financing city or county-wide operations. These might include hospitals, schools, roads, bridges and other community needs.
• Corporate bonds: Corporations also use bonds to pay expenses. Corporate bonds tend to offer more capital appreciation than government bonds. Before you invest in corporate bonds, it’s a good idea to take a look at the company’s cash flow, debt and the company’s business plan because they may pose a riskier investment than government and municipal bonds.

It’s important to understand that with corporate bonds, you must pay federal income tax on the interest you earn, whereas that’s not the case for government or municipal bonds.

Most Important Differences Between Dividend Stocks and Bonds

Beyond interest rates and returns, what are the important differences between dividend stocks and bonds? Let’s take a look at risk, capital preservation and return differences between the two.

Risk Variations

The major difference between stocks that pay dividends and bonds is the level of risk between the two. You may think you’re in good hands with dividend stocks due to their past performance (just check Morningstar for the proof of the successful history of various dividend stocks).

However, you can still lose money even while you’re earning money through dividends. Let’s say you held 100 shares of a dividend-paying stock on the S&P 500 index. Let’s say you received $500 in dividends but due to volatility in the stock market, you lost $4,000 in the value of your investment. In this case, the dividends might not win out.

Option to Preserve Capital

As a retiree or fixed-income investor, you can no longer really tap into a portfolio management strategy by getting steady returns from money market funds, CDs or other fixed-income investments. Money market rates hover close to 0%, so you need to tap into other investment objectives if you don’t want to dip into your original capital investment. High-yield bonds and dividend-paying stocks (bonds in particular, because you always get your initial investment back) can help you preserve capital.

However, it’s still important to remember that dividend stocks still carry more risk than traditional bonds.

Returns Vary

Dividend stocks deliver higher dividends (returns) compared to bonds, and have done so through almost all time periods, even during downturns in the stock market. Stocks deliver higher returns compared to bonds because they carry greater risk — if a company fails, you’ll likely lose your money if you invested in company stock. However, bondholders may recover their full or partial bond investment portfolio.

A stock's price will likely rise when the company performs well. You can expect a lower return on your investment when you invest in bonds. Stocks, including dividend stocks, carry more unpredictability but can offer a larger potential for a better return on your investment.

Since the year 1926, stocks on the stock market have returned an average of 10% per year. On the other hand, long-term government bonds have returned between 5% and 6%, according to investment researcher Morningstar.

Should You Invest in Dividend Stocks vs. Bonds?

Now, the final decision. Should you invest in bonds or bond funds? Seek out high dividends or look into the dividend yield and dividend growth of various dividend stocks? Take a look at the reasons to invest in dividend stocks and bonds.

Reasons to Invest in Dividend Stocks

Why might you want to invest in dividend stocks?

• Steady growth: Dividends usually grow steadily over time, particularly when you invest in the well-established companies like the high-quality Dividend Kings or Dividend Aristocrats. While there’s no guarantee, you can assume that these giants will continue paying dividends, beneficial if you’re looking for continued stock market profits. Dividend yield in low interest-rate environments can be higher than the interest rates of government bonds.
• Balm against volatility: Dividend stocks can lower volatility during bear markets. Due to their solid position in the market, dividend-paying stocks usually suffer fewer declines than non-dividend-paying stocks.
• Tax advantages: Qualified dividends are taxed at lower rates — at 0%, 15% or 20%, depending on your income and filing status. (Just note that a nonqualified dividend doesn't meet IRS requirements to qualify for a lower tax rate and is taxed as ordinary income by the IRS — it can be as high as 37%.
• Provides a buffer against inflation: Dividend stocks can provide a buffer against inflation, or the loss of purchasing power that results from inflation. Let’s say the price of a stock increases 4% over the course of a year, but inflation is at 5%. You actually lose 1%. However, if that same stock earned a 4% dividend yield, you earn returns that go over and above the rate of inflation.

Reasons to Invest in Bonds

Why invest in bonds? Let’s take a look at a few reasons why you might opt for bonds over dividend payers.

• Predictable income stream: Bonds can earn a predictable return. To figure total return, according to FINRA, take the value of the bond at maturity and add coupon earnings and interest that’s compounded, but don’t forget to subtract taxes and commissions. Subtract this amount from your original investment amount to understand the total return (or loss).
• Returns your entire principal: If there’s a definite benefit to bonds, you know that as the bond holder, you’ll get your entire principal back as long as the bonds are held to maturity. In this way, they can help you preserve your capital, as we mentioned earlier in the article.
• Offsets volatility: Let’s say you have a wide variety of high-dividend stocks and other types of stocks in your portfolio and a handful of bonds.Bonds can help you offset the risk that volatile stock holdings have in your portfolio.

Invest Based on Your Needs

Whether you’re after a high dividend yield or want consistency, dividend stocks and bonds can offer both. However, it’s important to consider each type of investments’ place in your wider portfolio. You may also want to add both investments to your portfolio! If you’re not sure, you may want to consult a financial advisor for the right personal finance advice you need for now and into retirement.

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