Passive Income Investing – Stock Dividends or Bond Interests

Money

12 Mar Passive Income Investing – Stock Dividends or Bond Interests

Stock investors invest for two objectives – capital gains or dividends. The former entails buying at a lower price and selling the stocks at a higher price to make the difference as the profits. The latter involves a regular and high distribution of cash to shareholders.

Conventionally, stocks are not thought to be invested for dividends. Else, stocks would be classified as a form of fixed income assets. Somewhere, somehow, things have changed. I guessed the following are the reasons for dividend investing.

First, Singapore observes the one-tier tax system and which means the dividends are distributed after corporate tax has been paid. And hence, dividends are not taxed on the individuals who received them. In short, tax advantage. Imagine you can build up a stash of dividend income and not subject to personal income tax!

Second, it is much more comfortable to see money coming into your bank throughout the year. Capital gains can be slow and it discourages impatient investors to wait. The instant gratification is much more attractive for most investors to stick to their stocks.

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Now, the golden question – if an investor is looking for passive income, why not invest in bonds where there is a high degree of capital guarantee and come with regular fixed payout?

There are advantages bonds have over stocks if the investor is going for yields.

There is a high degree of capital guarantee when you invest in bonds. Yes, some bonds default. However, it is definitely much more risky when it comes to stocks where the uncertainties and price volatility are greater. That said, bond prices can move up and down in between the issue and maturity dates and can be volatile too. But there is a maturity date that the bond holder can claim back the face value. It doesn’t happen for stocks. If the argument that the stock investor can participate in some capital gain, a bond holder also has the option to buy a bond at say 50% below its face value in a secondary market and eventually sell for 100% gain at maturity.

Bond holders rank higher than stock holders of the same company. Interests are paid to bond holders before the profits are shared with the shareholders. As such, the income from bonds is much more regular and predictable than dividends. Dividends can only be paid out of profits, which means there is a chance shareholders would not receive any dividends if the company make a loss that year. Moreover, profitability fluctuates and hence dividends would fluctuate too. In times of liquidation, bond holders are higher in the pecking orders to make a claim for the company’s assets.

By the way, interests from bonds are not taxed in Singapore too.

If you are agreeable by now that bonds are better candidates for regular passive income, do not be too happy yet.

The credit market is generally NOT available to retail investors.

The Singapore Government Bonds are traded on SGX but the yields are below 3% due to our Government’s good credit rating. There are only 6 corporate bonds listed on SGX at the point of writing. There are in reality countless corporate and government bonds traded privately among institutions and high networth individuals. They trade in large amounts say $250,000 minimally. And the bonds are taken up without the need to flow them to retail investors. It is easier to deal with a small number of bond holders than an army of them.

This means that the rich has access to higher yielding bonds and at the same time enjoy greater safety than shareholders. Who says life is fair? Suck it up, buddy.

The only way to access these bonds are through unit trusts or ETFs. Retail investors would need to pay fund managers to get these bonds. We have to pay a trustee to safeguard our money and bonds. We have to pay agents to access to the funds. In short, there are additional charges for retail investors to access the bonds while the rich probably pay less fees.

iShares Barclays USD Asia High Yield Bond Index ETF (O9P) is one of the bond ETFs which the retail investors have access to. It’s yield is in excess of 7% and the reason for such high yields is because the Fund buys into bonds with lower credit ratings. They can be Government bonds from emerging countries and corporate bonds which generally have lower ratings than their sovereign counterparts.

I noticed there is a relatively misconception that these lower grade bonds are risky. The fact is that stocks are even more risky. Stock investors should be rewarded much more for the risk they are assuming than bond holders. And that reward usually come in the form of capital gain rather than dividends. In other words, I am more in favour of investing for capital gains in stocks and income from bonds.



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6 Comments
  • La papillion
    Posted at 12:25h, 12 March Reply

    Hi Alvin,

    I think it’s Impt to highlight that a bond fund is different from individual bond. The main adv of bonds, which is capital guarantee upon maturity, is lost when we deal with bond fund. We lose this adv and exchanged it with another, which is diversification of individual company risk. It takes a lot to bring down a bond fund since there are so many companies (hopefully independent from each other!) but it only takes one for a company bond.

    The other thing is about pref shares. It has bond like qualities and in Singapore context, since almost all the pref shares listed are from banks, it’s as good as gold. I see it as a sufficient substitute for corporate bonds that are not accessible to average retail investors.

    • Alvin Chow
      Posted at 09:10h, 13 March Reply

      Yo LP, thanks for highlighting that.

      You are right that there is no capital guarantee in a bond fund and the diversification is another advantage to minimise risks.

      If each bond is capital guaranteed in the bond fund, the bond fund NAV should not reduce below the issue price if no one defaults. Collectively, the bonds would still be guaranteed to a certain extent. There is some proxy of capital guarantee, albeit not a direct one.

  • Divya
    Posted at 16:13h, 12 March Reply

    Useful article..thanks! I’ve long tried to figure why I couldn’t just buy bonds directly as a retail investor. I always like to avoid middle men (fund managers, agents etc etc.) as much as possible in my investments and couldn’t understand why bonds were not as easily accessible to me as a retail investor as stocks are. Now I get it :-(
    The point the reader above has made is a good one – we lose one adv (capital guarantee), but have exchanged it with a another good one (diversification). So maybe that can make up for the unhappiness that I have to invest in bond funds if I want access to bond market :)

    Never heard of pref shares, what are they?

  • La papillion
    Posted at 21:46h, 12 March Reply

    Hi Divya,

    Preference shares had both bond like and stock like qualities. It’s actually ranked above ordinary shares, so in the event of liquidation, the company will pay off the bond holders first, then the pref shares and then the ordinary shares. It has no voting rights but is paid a higher yield than ordinary shares. The maturity period can be x years or it can be perpetual (but with a date as the earliest redeemable option). You can click here if you want to read more about it (sorry alvin for the link…pls remove if not appropriate)

    I think what’s more interesting is that once you have an acredited investor status, you can sign up with the investment banks for an account. Then you can get those institutional bonds @ 250k a pop. But you don’t come up with your own money for the entire 250k. They will usually lend you say 50% of the 250k, and give you the difference between the coupon from the bond and the interest owed to them. So, it can increase the yield of the bond a few times.

  • La papillion
    Posted at 17:19h, 13 March Reply

    Hi Alvin,

    The thing that I don’t like about bond fund is that it is almost like a high dividend paying stock. Because of this, price becomes a major factor in determining whether the investment is a good one after a number of years. If the interest rate increases, the price of the bond fund would surely fall. But if you’re talking about individual bond, where it’s capital guaranteed upon maturity, the price can go up and down and you practically do not care about it. Why? Because you know that at the end of the tenure, you’ll going to get back the par value. If the price happens to drop below par, you’ll want to get more of it! The intrinsic value of an individual value is the par value, whereas that of the bond fund will go up and down accordingly to the underlying economic conditions. For a person who really really only want to get dividends without regards to volatility in price, I feel that individual bonds is the way to go. Not bond funds.

    • Alvin Chow
      Posted at 15:56h, 14 March Reply

      I agree that direct ownership of the bonds is better than investing through a bond fund.

      However, except for Singapore Government bonds, the options are very limited for the retail investors unless he or she is a wealth banker’s client.

      Hopefully we get to see more corporate bonds trading on SGX :P

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