If you are interested in investing for income, you have a number of options, including bonds and dividend-paying stocks. When prevailing interest rates fall, it is tempting to move your investments into dividend-paying stocks, which might offer a higher yield. While bonds and dividend stocks have some similarities, they are not interchangeable securities. Both have unique advantages and risks that you should weigh carefully against your investment objectives before you invest.
Debt vs. Equity
Bonds are debt instruments; stocks are equity securities. When you buy a bond, you are loaning money to the issuer in exchange for the promise of regular interest payments, plus a return of the face value of the bond upon maturity. Owning a bond does not give you an ownership position in the company. When you buy stock, you are buying a small piece of the company. You become a co-owner with all the other company stockholders. You are entitled to participate in the company's financial fortunes, whether those fortunes are good or bad. If the company turns a profit, the board of directors might vote to pay a portion of those profits to the stockholders in the form of a dividend.
Stocks of companies that have a long history of paying dividends during both bad and good economic times are called blue chip stocks or dividend stocks. These companies typically pay dividends on a quarterly basis. Bonds typically pay interest on a semi-annual basis, or once every six months.
Stocks vs. Bonds
The interest payments on bonds are a legal obligation. If the issuer fails to make its interest payment, it is in default of its bond indenture, and you have legal recourse against the company. Stock dividends are not a legal obligation. The company's board of directors can vote at any time to reduced or suspend dividend payments. In the event of a company liquidation, bondholders have preference on the company's assets. Common stockholders get to divide what's left, if anything, after the bondholders are made whole.
When it comes to investments, the only guarantee is that there is no guarantee. A company that has paid regular quarterly dividends for 50 years can have a disastrous year and cease paying dividends or even file for bankruptcy. Once-solid companies that have never missed a bond payment might default on their bond obligations. Conversely, a dividend-paying company might introduce a new product that takes the world by storm, and the market value of its stock might soar, giving you significant capital gains along with your dividend income. Prevailing interest rates might drop causing the market value of your bonds to increase, giving you the opportunity to sell your bonds for a profit.
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