Bonds now offer investors much more potential investment income. But I'd still rather buy a few S&P/ASX 200 Index (ASX: XJO) dividend stocks over bonds.
Investing in bonds essentially means buying debt. Generally, bonds are seen as less risky than shares because they are prioritised in the capital structure. If a company goes out of business, the bondholders are paid before shareholders (if equity holders get anything at all).
With interest rates now a lot higher, most bonds are offering investors a higher yield.
For example, Vanguard Australian Government Bond Index ETF (ASX: VGB) had a running yield of 2.8% on 31 December 2022, with a yield to maturity of almost 4%.
However, here's why bonds don't appeal to me that much. While they may have a fixed level of interest, that's essentially all bond investors will gain. One-off interest rate changes can impact bond valuations, as can concerns about bond investors being paid.
Skilled active investors may be able to buy bonds at a discounted price and sell them at a higher price. But, the income will largely form the basis of the return.
However, my preferred form of income investing is one that takes advantage of the power of compounding.
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This ASX 200 stock can benefit from compounding
If someone invested $1,000 in a bond with a 4% yield, they'd get $40 of income over a year. After the end of 12 months, they could invest the $40 into bonds, but they wouldn't be able to spend the income. If they spent the $40 income, they'd be left with the $1,000 again – no growth, assuming the 4% yield stayed the same.
However, let's use an ASX 200 dividend stock as an example.
Imagine I invested $1,000 into Washington H. Soul Pattinson and Co. Ltd (ASX: SOL) shares with a 4% grossed-up dividend yield. The total income would still be $40. But, an investor could spend that $40 and the business could still grow its dividend (and the investor's income) over the next 12 months as it re-invests its retained profit within the business for more growth.
According to Commsec, Soul Pattinson is expected to grow its annual dividend by 4.3% in FY24 compared to the projected FY23 payout.
Over time, ASX 200 dividend stocks can steadily grow and compound their earnings and dividends, even if investors spend that money on their living expenses.
Other reasons to like Soul Pattinson shares
It's an investment house, meaning it invests in other businesses, thus making it a diversified company thanks to its holdings. The company has investments in ASX shares like TPG Telecom Ltd (ASX: TPG), New Hope Corporation Limited (ASX: NHC), Brickworks Limited (ASX: BKW), Macquarie Group Ltd (ASX: MQG) and BHP Group Ltd (ASX: BHP).
It's also invested in private businesses such as electrical parts, agriculture, swimming schools and luxury retirement living.
The company has grown its annual ordinary dividend every year since 2000 and intends to keep increasing it. I think its income payments could be as resilient as corporate bonds, though nothing is guaranteed.
This ASX 200 dividend stock is already one of the largest positions in my portfolio, and I plan to regularly invest in it as time goes on. I like that the business can change its portfolio to be future-focused.
