Investing in Bonds for Income vs. Stocks
If you are a risk-sensitive investor, then bonds may be the perfect investment vehicles for you. Investing in bonds for income can result in predictable returns as compared to when you invest in the stock market. Bonds fall under the category of fixed income investment instruments due to their guaranteed interest payments along with the principal payment at maturity.
Generally, when you invest in bonds, whether government, municipal, or corporate, you are lending money to the issuer. In return, you receive periodic interest payments and the principal amount at maturity. While corporate issuers may default from paying back the loans, government and municipal bonds provide safer havens for investors.
Nonetheless, investing in bonds for income provides a better security than stocks because, in the case of bankruptcy, creditors including lenders like bond investors are paid first following the liquidation of a company. But people choose to invest in bonds for income instead of stocks for different reasons. Here are three of the most common factors that most people take into consideration.
Steady, minimal risk and predictable returns
When you are investing in bonds for income, you do so with a clear knowledge of how much you should expect to receive at certain intervals. For instance, if you invest in a 30-year government bond with an interest rate of about 2.5% fixed, it means that at the end of every year you should expect to receive 2.5% of your principle investment in your account.
There are other bonds that offer variable rates, but then those are considered to be a little riskier than the fixed return bonds. This means that for the fixed return bonds, the payments are low risk, steady and predictable. You can easily establish a sinking fund to offset a particular debt in your books using this kind of investment.
On the contrary, when it comes to investing in stocks for income, investors would have to target dividend-paying stocks. A good dividend-paying stock can be identified by analyzing the dividend history, dividend growth, dividend payout and the dividend yield.
A dividend history which shows consecutive payments for several years with a significant dividend growth rate of about 5% CAGR would be a good place to start. However, the dividend payout also needs to be at good levels if you are looking for further increments. In addition, the dividend yield should be good enough based on the prevailing market price, normally at least 3% yield, but 5% is even better.
As such, it is pretty clear that given the circumstances, it would be almost impossible to predict dividends when compared to investing in bonds for income.
Principle payment versus stock disposal value
When you invest in bonds for income, you not only expect to receive periodic interest payments, but also the principle amount invested at the end of the period. As long as the bond issuer remains solvent, you can expect to receive the full amount at maturity.
However, the same cannot be said when it comes to investing in stocks for income. While a company may continue to pay dividends in perpetuity, the value of the stock in the market may ultimately plummet. This means that when you decide to dispose of the stock, you may receive a less amount than the amount you used to acquire your stake.
Nonetheless, the reverse can also be true, if you invest in a stock that does not only guarantee dividend payments but also potential growth in value, you are likely to record some capital gain when you eventually decide to sell the stock. Shares of Apple have gained more than 5000% since the late 1990s.
This is another key factor which investors consider when choosing whether or not to invest in bonds for income or stocks. With bonds, investors can expect to pay income tax on interest received periodically whereas, in stocks, there is a withholding tax on dividends.
Dividends attract a withholding tax of 15% for U.S. citizens whereas foreigners are charged at 30%. On the other hand, interest income attracts a tax rate equivalent to your current income tax bracket, so if you are in the 33% category, that will be the rate used.
However, there is no tax charged on the principal amount at maturity whereas in stocks, if you make a profit based on the purchase price when you sell the stock, there is a capital gains tax to think about.
In summary, different investors will choose to invest in bonds for income instead of stocks for different reasons, but mainly these three are the common ones across the board.