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Dividend-paying stocks as an alternative for corporate bonds?

Seminar Paper 2014 16 Pages

Business economics - Investment and Finance

Excerpt

Contents

1 Introduction
1.1 Problem
1.2 Goal
1.3 Structure

2 Corporate Bonds
2.1 General observation and various bond types
2.2 Most common Corporate Bond risks

3 Dividend-paying stocks
3.1 General observation and specific characteristics
3.2 Dividend-paying stock risks

4 Comparison and further investment alternatives
4.1 Development of certain stocks and corporate bonds
4.2 Mixed investment portfolios

5 Conclusion

1 Introduction

1.1 Problem

Today´s highly complex and fast changing capital markets[1] offer a wide range of investment alternatives, which all hold different opportunities and risks for the investor.[2] As a first basic differentiation, one can distinguish between direct investments as a form of equity capital, and providing debt capital.[3] Based on the wide range of investments, it is not always that simple to make the right investment decision.

1.2 Goal

By taking a detailed look at the two investment alternatives, corporate bonds and dividend-paying stocks, prospective advantages and disadvantages of the two investment alternatives will be illustrated, as well as it will be carved out, if dividend-paying stocks, represent a preferred capital investment or if there are other mentionable alternatives.

1.3 Structure

Both investment alternatives will be illustrated regarding their different characteristics, their specific risks and the possible return yields for the investor. Afterwards, these relevant criteria and linked advantages and disadvantages will be compared by consulting recent and past developments. In the end an alternative investment type will be displayed roughly before the author brings it down to a round figure with a conclusion.

2 Corporate Bonds

2.1 General observation and various bond types

Corporate bonds are certificates of indebtedness, so securitized debts, which include the claim for money of the bondholder towards the issuer of the bond.[4] From the view of the bondholders, they do have a creditor stake in the company, which means that bondholders, in the event of bankruptcy, enjoy the top preference regarding repayment.[5] There are several corporate bond alternatives, with differences regarding the currency, if there is an obligation to pay, the bondholders interest, the term of the bond or optional exclusive rights.[6] Hence, in this paper, only the most important and most commonly used corporate bonds will be illustrated.

The so called Straight Bond, the most basic of debt investments, is characterized by a regular and fixed interest payment, also called coupon, no additional features, fixed duration and at the time of maturity payback of the principal that was primarily invested.[7] Deriving from these characteristics, Straight Bonds are also called Plain Vanilla Bonds, since there are no unusual features.[8]

Another mentionable type of bond is the Zero Bond (or discount bond), which does not include a right of ongoing interest payments for the bondholders. Instead of a periodic interest payments, this bond is issued at a price below its face value, while at the time of maturity, investors will be paid out with its face value. The difference represents the investors return.[9] Thus, the main difference is, that Zero Bonds involve only a single date of out payment.[10]

Floating Rate Notes are, just like the name suggests, bonds with a variable interest rate. Compared to the Straight Bond, the bondholders also have the right to receive an ongoing coupon payment, but the interest rate is not fixed for the whole duration, but for certain periods, just like three or six months.[11] Furthermore, the interest rate is not a percentage rate of the face value, but it is linked to reference interest rates just like the Euro Interbank Offered Rate (EURIBOR) or the London Interbank Offered Rate (LIBOR).[12] The EURIBOR is an average out of the interest rates at which banks in the Eurozone offer to lend unsecured credits to other banks.[13] The interest rate for the Floating Rate Note is normally not just equal to the reference interest rate, but also contains a spread, or a so called quoted margin, which is usually illustrated in basis points. The quoted margin is strongly connected with the corporate´s risk of default, the higher the risk, the higher the amount of added basis points has to be for a successful emission.[14]

2.2 Most common Corporate Bond risks

Whenever one has to make a decision, whether it is a decision about an investment, nor a decision remote from a financial context, there is always a risk.[15] An often-quoted definition of risk describes it as a possible harm or, in a context of investment decisions, a potential falling of asset positions.[16] Hence, bondholders should always bear in mind, that Corporate Bonds do not only bring different yield opportunities, but also different risks for the investors.[17] For a later evaluation, the most important risks of bonds will be explained roughly in the following.

The market risk, which reflects market intrinsic changes, subsumes the interest change risks and, when investing in foreign currency bonds, the foreign exchange risks.[18] A market interest rate increase for example leads to a market value decrease of fixed-interest bonds, which is equivalent to a real loss in case of a premature divestiture.[19] Vice versa, a decrease of the market interest rate, as of late practiced by the European Central bank[20], provides the possibility of a profitable premature divestiture.

Furthermore, the foreign exchange risk, which should be considered when buying foreign currency bonds, can be defined as the negative deviation from a scheduled target value, based on uncertain future foreign exchange developments.[21] For both, bondholders and the bond issuer, that does mean a general uncertainty about future values and a dependence on the development between the domestic and the foreign exchange rate.

A liquid bond can be described as a commercial paper, which can be sold at any time, in any quantity without a noteworthy markdown.[22] Hence, the liquidity risk describes the risk of a missing convertibility into cash, or the risk to do this without any markdown. If the bondholder is forced to realize the bond before maturity date with a markdown, the difference between buying-in price and the disposal price reduces the bond return.[23] A deterioration regarding the liquidity risk can often be seen during crisis situations.[24]

The default risk delineates the risk, if the issuer of the bond is and will be able to fulfil the obligations to pay.[25] In this case, the obligations to pay refers to the contractually fixed interest and redemption payments. This ability and therefore a trouble-free development of the investment is strongly determined by the issuer’s credit-worthiness. Therefrom, the higher the default risk, the higher, from the point of an investor, the expected remuneration for the bond.[26]

3 Dividend-paying stocks

3.1 General observation and specific characteristics

A stock or an equity share is a participation right or claim which represents a right to a share or economic co-ownership of a stock corporation. With its purchase the investor, or in this case equity capital provider, acquires several important rights.[27] Even though there are differences regarding the stockholders rights in different countries, the most important ones are often identical. Stockholders acquire the right to participate in the corporation, which includes the right to vote on important decisions at a General Meeting. Furthermore, if the company´s board of directors declares that the current or retained earnings will be paid out to its stockholders, they do have the right to receive this dividend on the share,[28] which is then the only interest payment entitlement for stockholders.[29] Those stocks, which implicate a dividend payout, are called dividend-paying stocks. Even though companies do not have to pay out the earnings to its stockholders, there are companies which pursue a policy of continuously dividend payouts, which makes dividend-paying stocks a mentionable investment alternative.[30]

To evaluate the actual return characteristics of a dividend-paying stock, the dividend yield can be calculated by using the following formula:

Dividend yield = (Annual dividend payout / share price) * 100 [31]

The calculated dividend yield, which is expressed as a percentage, makes it possible to compare the dividend-paying stocks with other commercial papers regarding their return characteristics.

3.2 Dividend-paying stock risks

It was mentioned in the previous chapter, that there are companies which pursue a policy of continuously dividend payouts, but nevertheless, from the stockholder’s perspective, there is no guarantee of receiving one and a dividend payout is just one out of several options of the profit utilization. Therefore, one risk while investing in dividend-paying stocks is to not receive any dividend payout and since a funded prediction of future payout are impossible[32], this risk should not be disregarded.

Stock investments always depend on the volatility, which can be defined as the fluctuation range of stock prices in a certain time frame. Just like the stock price represents the company’s value, the volatility of a stock represents the volatility of a company’s value.[33] Since there are several influencing factors for the volatility[34], which are not predictable either, the risk for a stockholder is to loose parts of his invested capital due to a negative fluctuation.[35] This risk of losing the invested capital arises from the general characteristics of stock trading and the volatility and is called downside-risk. An often unmentioned risk is the opposite upside-risk, which reflects the risk, that a stock investment makes a cashflow beyond its investors’ expectations.[36] When comparing the two investment alternatives, this risk can be disregarded.

Even if the stock market offers a fast convertibility into cash under normal circumstances, without a buyer a stockholder can´t sell his stocks and risks a markdown or even a total loss.[37] Furthermore, the stockholder as an equity capital provider has a secondary claim to assets, after the loan capital provider.[38]

4 Comparison and further investment alternatives

4.1 Development of certain stocks and corporate bonds

When comparing two investment alternatives, the investment horizon is an influencing factor, just like the risk and the expected return. By trend, the higher the holding period of stocks, the more attractive is this investment alternative for investors. Until today, in general stocks can only outclass bonds when the holding period is above 25 years![39] The following example can be used. A basket of shares, which reflects the MSCI-Index, which is a benchmark often used by foreign investors[40], was bought in 1979 for 100 Euro, has a value of circa 5.190 Euro in 2013. If the same amount of money would have been invested in German government bonds the return would have been only around 864 Euro.[41] In fact, this example uses government bonds, but despite that the explanatory power is not less important since these bonds behave in a same way regarding changes in market interest rates.[42] The comparatively stronger fluctuations of stock values, which can bring high returns but also high losses in case the investor has to sell the stocks, argues against stock investments, especially from the point of view of risk-averse investors. But this risk regarding stocks can be compared with the market interest rate risk for bonds, which depends on the sensitivity of the bond, so the vulnerability of a bond to interest rate changes. The higher the holding period or the lower the interest rate of a bond, the more sensitive it will react[43], which then explains why the holding period is a crucial factor when comparing stocks and bonds.

This first look at a comparison shows an advantage for stock investments regarding the long-term results. A closer look at the current dividend yield of selected dividend-paying stocks shows a similar finding. While stocks of BASF still offer a dividend yield of 3,4 %, the corporate bond with a holding period until the year 2017 only provides a return of one percent. Daimler stocks offer a dividend yield of 3,3% while the Daimler corporate bond, also with a holding period until 2017, only provides a return of 1,1%.[44] So while comparing returns relating to the past and recent dividend yields, one can assume, that there is an overall advantage for dividend-paying stocks, especially during global low interest rate policies.

In general one can observe, that successful and established corporations which are not in a growth stage anymore, tend to pay out a dividend to their stockholders[45], while young corporations, which are still in front of market penetration, won´t pay any dividend due to their much higher capital expenditure requirements.[46] But despite that general observation, investors should always bear in mind that there is no guarantee to receive a dividend. That means, on the one hand it is possible to argument with selected and recent stocks how dividend-paying stocks can offer a compensation for inflation but on the other hand, there are recent examples of established corporations that do not pay any dividend, just like the Thyssen group or the Commerzbank.[47] One can see that corporations that have paid a dividend for the last couple of years can surprise their stockholders from one year to another.[48] There are several reasons, even for established corporations not to pay a dividend. A capital intensive restructuring program or the entry into new business areas can sap distributable profits.[49]

It was mentioned in the previous chapters, that a premature realization can involve certain costs for both bonds and dividend-paying stocks. Therefore this factor can be disregarded in this comparison.

Due to the different advantages and disadvantages of the two investment alternatives against each other, there can´t be a simple and generally valid investment recommendation and any advantageousness of one of these alternatives can only be subjective and from investor to investor different. Therefore instead of investing in stocks or bonds only, investors can also consider mixed investment portfolios.

[...]


[1] Cp. Götze, U. (2008), Preface.

[2] Cp. Fischl, B. (2011), p. 2.

[3] Cp. Olfert, K. (2012), p. 22.

[4] Cp. Hauser, M. (2008), p. 118.

[5] Cp. Zantow, R. (2011), p. 261.

[6] Cp. Hauser, M. (2008), p. 119.

[7] Cp. Staroßom, H. (2013), p. 485.

[8] Cp. Stocker, K. (2012), p. 250.

[9] Cp. Kußmaul, H. (2010), p. 187.

[10] Cp. Breuer, W. (2012), p.188.

[11] Cp. Becker, H. (2013), p. 211.

[12] Cp. Kruse, S. (2014), p. 28.

[13] Cp. Weber, M. (2013), p. 43.

[14] Cp. Hägele, J. (2003), p. 135.

[15] Cp. Bamberg, G. ( 2012), p. 15.

[16] Cp. Wolke, T. (2008), p. 1.

[17] Cp. Brealey R. (2011), p. 156.

[18] Cp. Schiefer, D. (2008), p. 106.

[19] Cp. Steiner, M. (2012), p. 165.

[20] Cp. Europäische Zentralbank – Pressemitteilung (2014)

[21] Cp. Wolke, T. (2008), p. 133.

[22] Cp. Iversen, P. (1998), p. 210.

[23] Cp. Spremann, K. (2014), p. 21.

[24] Cp. Dowd, K. (1999), p. 187.

[25] Cp. Albrecht, P. (2008), p. 910.

[26] Cp. Elton, E. (2009), p. 523.

[27] Cp. Hauser, M. (2008), p. 84.

[28] Cp. El-Masry, A. (2013), p. 2129.

[29] Cp. Priermeier, T. (2006), p. 44.

[30] Cp. FIL Investment Services GmbH (2012)

[31] Cp. Hobes, D. (2012), p. 12.

[32] Cp. Hasler, P. (2011), p. 115.

[33] Cp. Strauß, S. (2009), p. 34.

[34] Cp. Hasler, P. (2011), p. 70.

[35] Cp. Hasler, P. (2011), p. 69.

[36] Cp. Hasler, P. (2011), p. 69.

[37] Cp. Lindmayer, K. (2014), p. 103.

[38] Cp. Perridon, L. (2012), p. 348.

[39] Cp. Lindmayer, K. (2014), p. 104.

[40] Cp. Dieu, L. (2014), p. 8.

[41] Cp. Allianz Global Investors Europe GmbH (2014)

[42] Cp. Allianz Global Investors Europe GmbH (2014)

[43] Cp. Allianz Global Investors Europe GmbH (2014)

[44] Cp. Schwarzer, J. (2014), p. 2.

[45] Cp. Hasler, P. (2011), p. 138.

[46] Cp. Hasler, P. (2011), p. 53.

[47] Cp. Schwarzer, J. (2014), p. 1.

[48] Cp. Finanzen.net Thyssenkrupp Dividende (2014)

[49] Cp. Hasler, P. (2011), p. 122.

Details

Pages
16
Year
2014
ISBN (eBook)
9783656903536
ISBN (Book)
9783656903543
File size
405 KB
Language
English
Catalog Number
v293004
Grade
2,0
Tags
dividend-paying

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Title: Dividend-paying stocks as an alternative for corporate bonds?