Bond Returns vs. Shares

Special Report

Bond Returns Versus Shares

November 21, 2022

Common Shares Provide Higher Total Returns Than Bonds

(From the November 18th Weekly Summary, slightly edited)

"The name is Bond, James Bond, and I'd like my martini shaken, not stirred." (which results in a watery martini, by the way: martini aficionados always get theirs stirred, not shaken with ice, but they do miss out on the sound of a martini shaker mashing lots of ice around.  A small audible price to pay for a superior experience, one supposes?)

So if James Bond can get it wrong regarding martinis, perhaps he might also be wrong regarding any long-term benefits of investing in government or corporate Bonds? (Note that the Cynergy Research approach for the past 13 years has been "avoid them like the plague.")

With that in mind, various commentators over the past 15+ years have said "Bonds appear more likely to offer “return-free” risk than “risk-free” returns."  Oh, so true, especially after tax, inflation, and interest rates that have skyrocketed in a short period recently: Bond Values have dropped like a stone, especially the 10-year to 30-year Bonds.

However, that has not stopped expensively-suited Bond Advocates at various brokerage firms during that entire period from pushing their product (the common pitch is "you need a 60-40 split between shares and bonds"), to the detriment of anyone who listened and bought in.  Meanwhile, stocks generally soared in value as well as paying large and increasing dividends in many cases.

This leads me to an interesting exchange I had the week of November 18th with an investor, whereby they ran across a TD Bank Bond that is maturing on December 9, 2025, offering a "yield to maturity" of 4.8% per year (of which the actual interest amounts to 1.13% per year and the remainder is a Capital Gain because the Bonds are currently trading at 89.17 cents on the dollar - woe to the folks who bought them at Par and want to cash out today...)   Sounds pretty good, right, when compared with cash in the bank, GIC's, or other lower-yielding alternatives?

But then I thought, "well, let's take a look at TD Bank stock and see what it serves up instead."

Well, the results were very interesting...

TD Bank common shares pay 4.1%, and the bank is increasing its dividend by 7% to 13% per year (see the Dividend lookup function here) so in 3 years at a 10% average annual dividend growth rate the YOC (Yield on Cost) will be 5.4%. In 5 years it's 6.6%.  These are very nice numbers.

Plus:

- They're buying back 2.7% of their shares each year, so the current EDY (Effective Dividend Yield) is 6.8% (Subscribers: see column AC in the Global Growth Model Portfolio).

- The TD dividend is eligible for the Canadian Dividend Tax Credit in non-Registered accounts, so for individual investors that means a 20%-25% or so tax rate instead of 40%-45% (on the Bond interest component.  The Capital Gain portion of the TD Bond is taxed at a similar net rate as Dividends).

- It is a reasonable certainty that if TD increases its dividend by 10% per year for 3 years its share price will also have compounded by about 10% per year, per various empirical studies on this matter, so that's a nice Capital Gain popper of 33% on top of all of the above.  The Capital Gain at the 5 year point is 61%, theoretically, Ceteris Paribus. Column AE says the "Projected Theoretical Total Annual Return (which is the Div Yield + Div Growth Rate)" is 14.1%, and the ""Adjusted" Projected Theoretical Total Annual Return (which is the Div Yield + Div Growth Rate + Share Buyback Rate in column AG)” is 16.8%.  That beats any bond return out there by a mile - corporate, government, or otherwise.

Therefore, on balance, for the Clements' Family Portfolio we are sticking with a Dividend Growth Strategy (DGS) rather than dabbling in Bonds.  The DGS for the Family Portfolio is tax-effective because of the Dividend Tax Credit for Canadian companies, plus via loading up on non-taxable TFSA's.

It was an interesting exercise.

By the way, for a real-world, non-theoretical example of the compounding effect re common shares, on September 21st John Heinzl of the Globe and Mail ran a story about buying CDN$10,000 of Royal Bank shares on September 21st, 2002, and holding them for 20 years though all the turmoil that's happened since then, including 2008/9 and 2020.  Well, the results are illuminating: the Total Return over the 20 years (including auto-reinvestment of dividends) was 12.45% per year on an annualized basis.  He concludes by saying "To put that into dollars, your initial $10,000 investment would have grown to $104,618 - a gain of 946% - before tax."

That leaves any Bond compounding in the dust over the same period: sorry, James.

By way of comparison, a $10,000 Bond with a 3.5% interest rate would have grown in value over 20 years to only $19,898, and that's after reinvesting the interest, just like the stock Dividends.  Even if you'd been fortunate enough to buy a 30-year Bond back in 2002 with a 6% coupon, it would have grown in value to only $32,071 in 2022 (plus it would be trading at a slight premium to Par today, probably around 125 cents on the dollar, so that’s another CDN$2500 in Total Return over 20 years, assuming there’s another 10 years to run before Maturity, and assuming you sold the Bond today to collect the $2500 Capital Gain.  In 10 years that temporary premium would evaporate because the Bond matures at Par).

The lesson regarding the article on bonds above is that stocks do outperform bonds over the long term, but we also know that bonds are far less volatile than stocks.  Therefore, if you’re going with an all-stock portfolio, possibly in pursuit of a dividend growth strategy, you have to be able to mentally handle the increased Volatility that comes with it.  If you can’t, then you need to consider bonds or some other low-Volatility security as a sizable component of your overall Portfolio.  For the Clements' Family Portfolio we are all-in on stocks in pursuit (primarily) of a Dividend Growth Strategy and have accepted the Volatility that comes with it.

They don’t teach that in any level of schooling.