One of the biggest stories in markets this year has been how stubborn inflation remains. Geopolitical tension in the Middle East spurred the Consumer Price Index (CPI) in March, which rose 3.4% year over year in August. However, even before this conflict, the CPI was still well above the Federal Reserve's 2% target.
The market is starting to believe that inflation will stick around for a lot longer than initially expected. This could explain why Treasury yields, particularly for 10-, 20-, and 30-year terms, have risen significantly in the past 12 months. The assumption is that interest rates will stay elevated for an extended time, at least compared to most of the 2010s.
Income investors looking to allocate capital are now faced with a crucial decision, one that might have been easier to make in the past. Is it smart to put money in dividend stalwarts, such as Coca-Cola (KO +0.22%) and Procter & Gamble (PG +0.36%)? Or should U.S. government bonds be on your shopping list?
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Owning U.S. government debt limits downside
As of this writing on the morning of Sept. 16, the 10-year Treasury yields just under 5%. At the same time, investors can earn more than 5.3% on 20-year and 30-year bonds. For the sake of this analysis, I believe it's best to focus on the 10-year Treasury, as this is a reasonable holding period that's also comparable to long-term stock investing.
It's hard to beat a risk-free yield over a decade, which is backed by the full faith and credit of the U.S. government. That's a stable source of income that investors can depend on. Even better, these financial instruments are exempt from state and local taxes, which can boost the final returns.
If you don't plan on holding these Treasuries for the entirety of their terms, then there is risk that you'd bear. First, interest rates can and will continue to change. If rates rise, then bond prices fall. If rates fall, then bond prices rise. The longer the duration of the bonds in your portfolio, the more sensitive they are to interest rate fluctuations.
It's also important to think about inflation. If changes in prices across the economy increase, investors who buy Treasuries today face the risk that they might not earn a yield that compensates for inflationary pressures. This can result in a negative real return.
NYSE: KO
Key Data Points
Leading dividend stocks provide growth potential
I'd argue that the better choice would be to simply own blue chip dividend stocks. The downside should be highlighted, though. Owning equity positions in companies exposes investors to the risk that leadership teams unexpectedly reduce or pause their payouts. There is also the possibility that these businesses will lose their competitive positions. As a result, stock prices could fall, causing capital losses.
However, investors have benefited tremendously by capturing growth potential. U.S. Treasuries don't provide this valuable tailwind. That makes up for Coca-Cola's 2.4% dividend yield and Procter & Gamble's 2.95% dividend yield being much lower than the almost 5% that 10-year Treasuries pay.
In the past decade, the beverage stock's dividend has increased by 51%. The consumer goods company's payout has climbed by 63% during that time. U.S. debt investors won't see these gains.
Given their track records, the risk that dividends get disrupted seems improbable. Coca-Cola has raised its dividend for 64 straight years. Procter & Gamble has paid a dividend in a mind-boggling 136 straight years, with a 70-year active streak of boosting the payout.
We also haven't touched on the ability of stock price appreciation to add to returns. Shares in Coca-Cola and Procter & Gamble are up 108% and 67%, respectively, in the past decade. That's a powerful differentiator that further supports the case for owning these dividend stalwarts over U.S. Treasuries.
