The Bank of Canada’s aggressive interest rate hike pushed bond yields to their decade high, making fixed deposits more attractive than dividend stocks. This shift pulled down dividend stock prices throughout the rate-hike cycle and inflated the dividend yield. After 20 months of this trend, which is a better investment: bonds or a Dividend Aristocrat that pays >7.5% yield? Let us analyze the expected returns in both options and see which is offering better returns.
Investing $5,000 in a bond that gives a 5% yield
Bonds give fixed coupons every six months and the invested amount on maturity. If you buy a five-year bond with a 5% coupon for $5,000, it will give you $125 every six months. You can also sell the bond in the bond market at a premium or discount depending on the market interest rate. Since the interest rate has peaked and is expected to fall next year, the 5% bond is likely to sell at a premium. The highest the bondholder can get is $5,000 + $1,250 ($125 x 10 coupon payments).
The correlation between bond yield and dividend yield
Bonds are low-risk investments as they are debt instruments that have an obligation to pay. Stocks, however, have no obligation to pay dividends. The management decides how much dividend to give depending on the business situation. Shareholders bear the risk of a dividend cut and stock price decrease.
When bond yield rises, investors switch to bonds, as they are getting a better return for low risk. In such a scenario, stocks offer a risk premium to retain investors. The bearish stock price momentum has inflated dividend yields.
Investing $5,000 in a dividend stock that gives a 7.5% yield
Economists believe the Bank of Canada will likely begin a rate cut in 2024. When interest rates fall, the stock market will see renewed interest, driving stock prices that fall through the rate hike.
Enbridge (TSX:ENB) stock fell 19% throughout the interest rate hike, which inflated its dividend yield to 7.7%. For a brief moment in October, the yield also reached 8%. The stock fell, even when the company’s profits and distributable cash flows (DCF) grew steadily. The company is acquiring gas utilities in America to stabilize its 3-5% DCF growth as the energy industry shifts from oil to greener options such as natural gas, a bridge between fossil fuel and renewable energy.
Enbridge’s management has shown confidence that the acquisition will not impact the 3-5% annual dividend growth.
| Year | Expected dividend per share (3% CAGR) | Annual dividend on 105 Enbridge shares |
| 2024 | $3.66 | $383.93 |
| 2025 | $3.77 | $395.45 |
| 2026 | $3.88 | $407.31 |
| 2027 | $4.00 | $419.53 |
| 2028 | $4.12 | $432.12 |
| Total | $2,038.35 |
If you invest $5,000, you can buy 105 shares of Enbridge at $47.5 per share and lock in $383.9 in annual dividend. If Enbridge continues to grow its dividend at a 3% compounded annual growth rate (CAGR), you can earn $2,038 in total dividends in five years. Moreover, your $5,000 initial investment could surge as the stock price returns to its average trading price of more than $50.
Which is better: Bond yield or dividend yield?
You get a $750 additional return in Enbridge plus a chance for capital appreciation, making a >7.5% dividend yield a better investment for low risk. You can also explore slightly riskier stocks like BCE and CT REIT. They offer attractive dividend yields and dividend growth.
