Get More Income with My Double-Barreled Investing Strategy

published 29 September 2010

Bonds sure aren’t steals. Prices of many long-term bonds issued by first-rate companies have climbed 15% to 20% over the past two years. By contrast, many blue-chip stocks look cheap on the basis of their price-earnings ratios and dividend yields. Companies can raise the dividends they pay, while the interest they pay on bonds is almost always fixed. And once Congress deals with current income-tax rates, it’s more than likely that taxes on dividends will remain well below levies on bond interest.

On balance, then, blue-chip stocks appear to be better buys than corporate bonds. Of course, stocks typically carry more risk than bonds. If third-quarter earnings are weak and the tone of company comments is negative, stocks will get creamed. Bond prices won’t falter until interest rates start to climb (prices of fixed-income investments move in the opposite direction of yields).

So if you need income and would rather not settle for the puny interest rates offered by government bonds, here’s an idea: Find several companies you understand and admire and are content to stick with through several market and economic cycles. Then buy the shares and the bonds. Figure about $2 worth of stock for each dollar in the company’s bonds. Choose six firms and you’ll book 24 quarterly dividends and 12 semi-annual interest payments a year. That’s potentially a paycheck every ten days. (This is not meant to be an overriding asset-allocation strategy, only a way of hedging your sources of investment income between that generated from bond interest and that derived from a company’s profits.)

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There is merit to this method. “It’s two different bets,” says Bruce Weininger, a partner in Kovitz Investment Group, a Chicago money-management firm. “With the bond, you’re just hoping the company stays in business. You’re not making any other judgment on how the company’s going to do,” as you do when you own a stock. Weininger frequently holds both a company’s shares and its bonds in client accounts. Two current examples are Johnson & Johnson (stock symbol JNJ) and Wal-Mart Stores (WMT).

Some of the highest-quality corporate bonds pay so little today that they’re hardly worth considering. For example, in mid August, J&J, one of four nonfinancial companies in the U.S. to still have a triple-A debt rating (see Last Four Triple-A Stocks Standing), issued $1 billion of new bonds at 2.95% for ten years and 4.5% for 30 years. That’s hardly more than the U.S. Treasury pays. At the same time, J&J’s stock pays a dividend yield of 3.5%, and payouts have grown at an annualized rate of 10.4% over the past five years. An impeccable credit rating is responsible for both J&J’s stingy bond yield and its bright dividend prospects. Triple-A status keeps borrowing costs down, while giving the company room to pass cash to the shareholders rather than keep it to buttress the balance sheet.

Because they came to market with interest rates well above current yields, many older corporate bonds are trading at premiums to par value. That means you may have to pay, say, $1,150 for a bond that will pay $1,000 at maturity (such a bond would be quoted at $115). You shouldn’t automatically avoid a bond selling at a premium price. The current yields of many such bonds—the interest coupon divided by the purchase price—are quite attractive. As long as inflation and interest rates stay low, the above-market-rate interest coupons of those bonds provide adequate compensation for their higher prices. Just be sure you don’t buy a bond that can be called—that is, redeemed prematurely—in a year or two at face value, because you’ll lose more principal than you will have collected in interest.

I scoured the list of first-rate companies that offer decent-to-above-average dividend yields and have shown a pattern of boosting their payouts regularly. Then, using the continuous real-time corporate-bond trading ticker at www.investinginbonds.com, an incredibly useful free Web site, I hunted for bonds issued by the same companies. All of the companies listed below are investment grade, meaning they are rated triple-B or better. Some issuers, such as AT&T and IBM, have dozens of bonds outstanding. You needn’t insist on the particular issue listed below. Symbols and prices are for the stocks; all prices are as of September 28.

Topics

Income Investing

Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.