Investors can earn income in one of two primary ways – dividends paid on stocks or interest paid on bonds. While both generate income, stocks and bonds have remarkably different risk profiles. Stocks tend to be more volatile than bonds because stocks are more sensitive to the state of the economy and changes in a company’s financial performance. Stocks also face a higher degree of income uncertainty since companies may choose, but are not obligated, to pay dividends to shareholders. In contrast, borrowers are contractually required to pay interest on their bonds at specified intervals. Bondholders also rank more senior in a company’s capital structure and are typically paid back before stockholders if a company declares bankruptcy. While bonds tend to produce lower price returns, their contractual interest payments and seniority may make them a less risky income source.
The last decade of low interest rates made it difficult for savers to generate income. If savers wanted to earn more income than bonds offered, they turned to the stock market. Figure 1 below tracks the number of S&P 500 companies with a dividend yield above the yield on a 5-year Treasury bond. From 2008 through 2022, many S&P 500 companies offered higher yields than the 5-year Treasury bond. However, the situation changed considerably during the past 12 months as interest rates rose. As of July 11th, only 51 companies in the S&P 500 paid a dividend yield above the yield on a 5-year Treasury bond. It is the fewest companies since 2007, a period when savers could generate more income by owning bonds rather than stocks.
Bonds sold off in 2022 as the Federal Reserve raised interest rates, but those interest rate hikes now present an opportunity for savers. Figure 2, which graphs the yield across various U.S. Treasury maturities, shows bonds are now more competitive as an income source. Yields on shorter maturity Treasuries approach 5.5%, and investors can lock in a yield near 4% on longer maturity Treasuries. Rather than relying on stocks to generate income, savers can now earn a higher level of income by owning bonds and diversifying their portfolio.