The Motley Fool

Is it game over for ‘bond proxy’ FTSE 100 dividend stocks?

Global markets have fallen sharply over the last week as investors have panicked about higher bond yields in the US.

One particular group of stocks that has come under significant pressure is the so-called ‘bond proxies’. These are blue-chip companies that pay reliable, bond-coupon-like dividend payments, such as Unilever, Diageo and British American Tobacco, which were seen as an alternative source of income when bond yields were at rock-bottom rates in recent years.

Now that bond yields have risen (the 10-year US Treasury yield recently rose above 3.2%), many investors are arguing that it’s no longer worth taking the risk of investing in these kinds of stocks, and that bonds are a better investment.

So, is it game over for the bond proxies? Are bonds a better investment than FTSE 100 dividend stocks?

Flawed argument

I can see the point that bond proxy bears make, as bonds now offer a healthy yield with lower risk than stocks. In other words, why buy a stock yielding 3% when you can own a long-term government bond that pays 3%?

However, I also think this is a flawed argument, because it ignores one key concept, and that’s dividend growth.

Dividend growth

Dividend growth is something I often write about, because it’s an important, yet under-appreciated, concept in investing. You see, if a company is consistently increasing its dividend, year after year (as Unilever, Diageo and BATS have done for many years) the results can be extremely powerful over the long term.

When a company regularly hikes its dividend, not only does the investor pick up a higher dividend payment, but they are also likely to see long-term capital gains, as the higher dividend payouts make the stock more attractive over time. In short, dividend growth investing is a potent strategy, and high-quality dividend growth stocks are far more attractive long-term investments than government bonds.

This is a concept that star portfolio manager Nick Train discussed earlier this year. Pointing out that Unilever has compounded its dividends by 8% pa since 1952, Train stated that it’s important not to make the category error of conflating ‘growth companies’ with bond proxies.

Inflation protection

It’s also worth pointing out the key flaw of bonds is that they provide no inflation protection. With bonds, your income is ‘fixed’, so you receive the same income payment every year until the bond matures. This means that with inflation rising at 2-3% per year, your income stream is losing purchasing power every year. Is that a good long-term investment?

In contrast, Diageo and British American Tobacco have lifted their dividend payouts by annualised rates of 6.6% and 11.4%, respectively, over the last decade. Meanwhile, Unilever has compounded its dividends by 8% per year since 1952, as I noted earlier. That means the income stream growth on these stocks has outpaced inflation by a wide margin.

In my view, it makes little sense to compare a company like Unilever, which is consistently increasing its dividend at an inflation-beating rate, to a fixed-income security. They’re completely different financial instruments.

Ultimately, dividend growth stocks are far more attractive long-term investments than government bonds. Yes, bonds are lower risk, but they simply don’t offer the long-term total-return prospects and inflation protection that many FTSE 100 dividend stocks do. The key with dividend stocks is to focus on dividend growth.

Want To Boost Your Savings?

Do you want to retire early and give up the rat race to enjoy the rest of your life? Of course you do, and to help you accomplish this goal, the Motley Fool has put together this free report titled "The Foolish Guide To Financial Independence", which is packed full of wealth-creating tips as well as ideas for your money.

The report is entirely free and available for download today, so if you're interested in exiting the rat race and achieving financial independence, click here to download the report. What have you got to lose?

Edward Sheldon owns shares in Unilever and Diageo. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.