The safety of an income stream -- even a tiny one -- and return of principal backed by the U.S. Treasury are attractive characteristics. However, with currently puny yields and recent inflation reported at 1.7%, U.S. 10-year notes virtually guarantee a loss in purchasing power.
I've thought bonds have been overpriced for some time (and been wrong) and recently have been comparing the prospects for 10-year Treasuries against dividend-paying stocks. For this matchup, five stocks from the Dow Jones Industrials (INDEX: ^DJI ) will run a 10-year discounted cash flow gauntlet against Treasuries. The stock team was chosen to get a good mix of strong businesses with established dividend track records, which they maintained through the rough markets a few years ago. I have CAPScalls on and own McDonald's (NYSE: MCD ) and Intel (Nasdaq: INTC ) , and I have a CAPScall on Johnson & Johnson (NYSE: JNJ ) . 3M (NYSE: MMM ) and Travelers to round out the stock team.
Johnson & Johnson has been keeping stockholder accounts healthy with dividend raises every year for a half-century. McDonald's has been serving up beefier dividends every year since its first payout in 1976. Intel is a relative newcomer to the dividend game, but has been computing higher payouts for nine consecutive years and processed two hikes in 2011. Regular dividends have been the policy at Travelers, with 140 years of continuous payouts. And 3M puts this statement at the top of its investor relations site dividend page: "3M has paid 382 consecutive quarterly cash dividend[s] and increased the annual dividend for 54 consecutive years."
Recent Stock Price
5-Year Dividend CAGR
|Johnson & Johnson||$68.04||3.59%||8%||Health care|
Sources: FINVIZ.com and author's calculations. CAGR: compound annual growth rate.
The Treasuries and company stocks were compared using the net present value of the investment, coupon or dividend payments, and value at the end of 10 years. Since my crystal ball is a bit cloudy, the following assumptions were used to estimate the unknowns:
- Treasury yield is rounded to 1.65% and the notes return full face value at maturity.
- Stocks start with their current dividend rate and raise the payment each year in the same quarter as the past several years. Dividend hikes are assumed to be 75% of the past five year's compound annual growth rate or 8%, whichever is less.
- Stock prices are assumed to be 10% higher at the end of ten years; less than a 1% compound annual growth rate.
- Future values are discounted at the most recent consumer price index rate reported by the Bureau of Labor Statistics, which is 1.7%.
The model was also run with no dividend growth to find how much each stock would need to lose over the ten years for the Treasuries to come out ahead.
No surprise that that Treasuries lose purchasing power with the yield below inflation, but it may be surprising to some that all five stocks beat the notes under these assumptions. If dividend growth flatlined, the stocks would still need to take sizable price hits over the decade before Treasuries would outperform the stocks.
Change in Purchasing Power
Stock Loss Needed (No Dividend Growth) to Equal 10-Year T-Note Return
|Johnson & Johnson||35.8%||(21%)|
Source: Author's calculations. N/A = not applicable.
These aren't expected returns for the stocks; this scenario crimps dividend growth and assumes minimal growth in the stock price. The exercise is intended to compare several income streams and get a handle on the risks.
I have no idea how stock prices or interest rates will move over the short term, but over a time horizon of many years, it's hard to see any scenario where long-term Treasuries at today's yields can outperform quality dividend-paying stocks.
Now it's your turn. Add a comment with your thoughts or a stock you'd like to see in a future match-up with Treasuries.