A Stock, a Bond or Both?

Marc Lichtenfeld By Marc Lichtenfeld
Chief Income Strategist, The Oxford Club

Market Trends

In my monthly newsletter, The Oxford Income Letter, AT&T (NYSE: T) is listed as a “Buy.” I like its nearly 5% yield, steady cash flow and market domination along with Verizon (NYSE: VZ). I’ve had the stock in the portfolio since February 2014.

Bond Strategist Steve McDonald is also a fan of Ma Bell. As a result, he recommended buying a 10-year AT&T bond with a 4.25% coupon. That means investors will receive a payment of $42.50 every year in interest for every bond they buy.

Why would we recommend both a bond and stock of the same company in the same newsletter?

Because they’re different asset classes.

It’s important to understand that if you had a portfolio with just a handful of investments, I wouldn’t recommend that you own the stock and bond of the same company in that portfolio.

But a well-diversified portfolio would include not only different companies, but different size companies, sectors, risk levels and types of assets.

A stock, even an income stock, is usually bought for its growth prospects, not just its dividend. A bond, while its price can rise, is usually purchased for income and safety.

How Safe Is Safe?

Safety is the key word.

AT&T is a pretty safe stock. The company makes gobs of money. It generated $17 billion in free cash flow last year. Earnings are expected to grow 7% per year through 2021.

It provides a service that everyone in the U.S. and billions more around the world use. The company has been around for decades. Though business cycles ebb and flow, it won’t disappear anytime soon.

It’s one of the safer stocks you’ll find.

Yet the stock price can still fall, even if business is doing well.
In 2008, during the height of the financial crisis, the company’s profits actually increased from $12 billion to $12.9 billion. Yet as the market collapsed, AT&T’s share price dropped 37%. It still paid and raised its dividend, but the price of the stock dropped dramatically.

If you had a stop loss, had a shorter-term investment horizon or simply could not handle that kind of volatility, you’d have sold your stock when it fell.

A bond typically doesn’t have the same goals as a stock. When you invest in a bond, you usually are not as concerned with the day-to-day changes in price. If something very negative occurs and the price of the bond falls dramatically, sure, you’re going to pay attention. But you’re not glued to your screen like you might be with your stock portfolio.

A bond investment is usually made with the plan to hold it until maturity. At maturity, as long as the company is solvent, you get your principal back. This can vary slightly depending whether you paid above, below or at “par value.”

Par is usually $1,000. So if you bought the bond for $1,000 when it was issued, at maturity you’ll receive $1,000. If you bought it for $980 in the open market, at maturity you’ll receive $1,000, making an extra $20 in addition to the income you received while you held it. If you bought the bond for $1,020, you’ll receive $1,000, taking a $20 capital loss, although you’ll have received income during the time you held it.

With a bond, you are typically sacrificing potential growth for safety – not only in the price of the asset, but in the income received.

AT&T has raised its dividend every year for 33 years. Today, AT&T pays a quarterly dividend of $0.49. Last year, it was $0.48. Next year, it’s very likely going to be $0.50 or higher. When you invest in a stock like AT&T, you know you’re going to receive more income every year.

Bond interest stays the same no matter what. The company could have record-setting profits or it could have a terrible year. And shareholders will still receive their $42.50 per year for every bond they own. It won’t change.

It’s important to understand that bonds are not completely risk-free. Companies have defaulted on bonds before, but with a highly rated bond like AT&T’s, it’s pretty rare.

You can see how an investor, who likes AT&T or another similar company, could put a portion of their investment in an asset class (stocks) that is geared toward income and growth, with another portion in bonds, whose aim is income and safety.

We don’t often recommend owning the shares and bonds of the same company. But in this case, it makes sense.

Good investing,

Marc

P.S. Steve recently discovered a group of bonds that could gain up to 400%. For the details on these “super bonds,” click here now.