Fixed Income or Growing Income?



Volume 90 No. 11 - November 2019


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In July, we made a case for investing in bonds, however, we continue to have confidence in owning stocks for both income and growth investors. After all, equities have treated us and our investment income well—for years now. Should you own stocks for higher income?

Why should you consider keeping or even adding, stocks to your portfolio when “Amber Lights Are Flashing?”

While bonds are debt issued by companies, stocks represent shares of ownership in them. Traditionally, bonds are thought to be safer. Stocks are said to have more risk, in the short-term, at least.

Long-term, stocks have outperformed bonds in generating investment income for investors. Why? The answer starts with the relationship between risk and return. It goes beyond that as well.



Bonds: Safe Investment Income?


When markets start to stall, many investors may sell at the bottom and run for the safety that bonds seem to promise. As we said in July, bonds help you sleep at night. They bring balance, but at a cost.

Bonds are long-term assets that offer interest income set at a fixed rate. The companies issuing bonds promise to repay investors, regardless of what the equity markets do. This becomes attractive in uncertain markets. Companies can default on their repayment promises, of course; so, bonds are never risk-free.

Bonds react to rising interest rates and economic stimulus packages differently than stocks. When interest rates rise, the fixed-rate interest payments on bonds become less attractive and the value of the bond decreases on the open market.

In the short-term bonds can represent less risk than equities, however, in the long-term the potential effect of inflation and a fixed income may favor stocks. In the markets, as return finds equilibrium with risk, the return offered by bonds generally underperforms stocks. So, while the perception that your money may be safer in bonds might well be valid, you may also find yourself accepting lower returns and seeking new ways to earn investment income.

Also, the very feature that makes some bond investors sleep better at night—locked-in interest rates—also locks in investment income—even in a rising interest rate environment. Over the short term, that might be fine. But, long-term, in a rising interest-rate environment, bond investors miss out on some of the investment appreciation enjoyed by investors in equities.


Stocks


In a long-term, buy-and-hold strategy, stocks historically have outperformed bonds. Recent research by financial news website The Balance found that, from 2004-2014, S&P 500 stocks logged an average annual return of 8.1% while the US domestic bond market posted returns averaging 4.6% annually. That time period includes the Great Recession when stocks took the full brunt of one of the fiercest bear markets in recent history.

Beyond returns, however, why should investors still embrace stocks in uncertain economic waters?

Many stocks can be a regular source of investment income. Bond investors appreciate the steady cadence of bond repayments; stocks too offer regular payments of interest income—through dividends. Dividends represent a portion of a company’s earnings that are paid back to its shareholders. While the underlying companies are not required to pay dividends, most do since they are established, reliable, well-known companies.

Dividends are often taxed at lower rates than bond interest income. While the IRS taxes most interest income from bonds at regular income tax rates, qualified dividends that investors receive from stock investments may be taxed at a lower capital gains tax rate; given your tax situation may be as low as 0%.

Stocks represent growing income, not fixed income. With bonds, you know what you get. You pay for a bond by lending the issuer your money. That issuer then promises to pay back that loan over time, per the terms of the bond. With bonds, you are signing up for a set of fixed payments. This is how bonds came to also be known as fixed income.

Nothing about stocks is fixed. But, as stocks appreciate in value and pay dividends, in many cases, your income and your investment can grow—far beyond where a bond investment is capable of reaching.

Stocks allow for inflation protection. When inflation rises, the interest rate set on a bond does not. When you are earning interest below the rate of inflation, you lose money in real terms because the value of your investment buys less now than it did at the time of your investment, even if the amount of dollars represented by that investment has increased.

Stocks rise with the markets, which seem to price in inflationary pressures. In addition to the rising value of your stock, dividends—derived from corporate profits—may also keep pace with inflation.

But the real value in stocks may be in their upside potential, represented by their ability to grow in market value and increase their dividend payments to investors.



Following the Fortunes


Along with risk comes reward … or potential market loss. Stocks allow you to follow the fortunes of the issuing company. If that company’s growth is spectacular and exponential, so too can be the value of your investment. If that company’s growth is mediocre, your investment’s results may be disappointing too. While bonds can provide a safer port in uncertain waters, stocks should not be forsaken when we see the first hint of yellow lights on the horizon. Don’t blindly sacrifice the returns and other benefits that stocks have to offer. Just choose wisely when constructing your portfolio.



Stocks or Bonds—Which one is right for you?


The answer may be stocks and bonds, not stocks or bonds. The best portfolios, for the long-term, buy-and-hold investor, tend to be those that are diversified. While stock returns will always be more difficult to predict, it’s that volatility that drives up the returns that—in aggregate and over time—outperform bonds. Still, as bonds offer the security of a fixed series of payments over a set amount of time, adding them to a portfolio may be wise, especially in cases where you can see a need to depend on that investment income down the road, such as in retirement. In the end, diversification wins the day and offers investors the best of both worlds and the worst of neither.


Investment Counsel Inc. is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.

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