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.
Why do stock investors invest for dividends?
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 be subjected 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. Instant gratification is much more attractive for most investors to stick to their stocks.
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 a regular fixed payout?
3 Advantages of using Bonds for passive income
Bonds have several advantages 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 riskier 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 when the bond holder can claim back the face value. It doesn’t happen for stocks. If the argument is 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 dark side of Bonds Investing
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 11 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 net worth 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 is 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 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 retail investors have access to. Its yield is in excess of 5% 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 riskier. Stock investors should be rewarded much more for the risk they are assuming than bondholders. 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.
