Shares vs bonds: which offers the best opportunity for income seekers?

Bonds are back. For years, income-seeking investors avoided the fixed-income sector, with super-low interest rates keeping bond yields depressed. But the tighter monetary policy since the end of 2021 – imposed as central banks have sought to tame inflation – has changed the game.

Even the most secure bonds now offer decent levels of income. The yield on 10-year US Treasuries, issued by the US government, is currently 4.59%; on short-dated UK gilts, meanwhile, yields are a tad higher at 4.65%. Many corporate bonds, issued by companies, offer significantly more.

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Compared against equities, this level of income looks very attractive. The average stock in the FTSE 100 index of blue-chip shares offers a yield of around 4%, although there is enormous variation from one company to another.

All of which begs an obvious question: should investors prioritising income now dump equities in favour of bonds?

Higher yields for bonds, but don’t write off shares

There isn’t a straightforward answer, warns Scott Gallacher, a director of independent financial adviser Rowley Turton. While bonds do currently offer more income than equities, that won’t be the only consideration for many investors, he points out.

He says: “The increase in interest rates, and therefore yields, has made bonds much more attractive for income seekers, particularly for those with a short-term horizon; I see this as a return to normality that should suit a more traditional approach to portfolio construction.

“However, while bonds generally offer higher yields than shares, shares historically have provided investors with increasing dividends and better capital growth prospects than bonds. So, for those with a longer-term horizon, needing a long-term income that requires some degree of protection against inflation, shares will likely remain an essential part of their portfolio planning.”

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This is a multi-dimensional debate. Investors need to think about the levels of income on offer right now from bonds and equities respectively, but also about how that income is likely to change in the future. And they need to keep the capital value of their investment in mind too.

Ben Yearsley, investment director of Shore Financial Planning, also urges investors not to think in binary terms. “For short-term investors, it is hard to turn down 6.5% from high-quality investment grade [corporate bond] funds – in a tax-free individual savings account (ISA) or self-invested personal pension (SIPP) wrapper, the total return potential is a no-brainer,” he says.

Equities provide potential for dividend growth

However, he notes that for longer-term investors growth in income is essential, which can only be provided by equities. He adds: “Many equity income managers I'm speaking to are pencilling in dividend growth of between 5% and 10% next year.”

The important point to grasp here is that while yields on bonds vary over time, the cash value they pay – known as the coupon – does not. This is why bonds are known as fixed-income investments. If a bond worth £1 pays 5p income today, it will yield 5%. In a year’s time, the bond price might be £1.10, but it will still pay a coupon of 5p; in which case, the yield will have fallen to 4.54%.

Dividend payments on equities, by contrast, are not fixed – companies pay out what they feel they can afford to shareholders, depending on their performance in a given year. Many companies aim to increase dividends as regularly as possible.

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Yields don’t always make it easy to understand this. A share worth £1 today and paying a dividend of 5p is yielding 5%. In a year’s time, if the share price has risen to £1.20, say, and the company is offering a dividend of 5.5p, the yield will have fallen to 4.58% even though the cash value of the income has increased by 10%.

Nevertheless, the potential for dividend income to rise over time is valuable – it protects the value of your income from the eroding effects of inflation. And with inflation still elevated in most Western economies, that’s especially important.

Richard Hunter, head of markets at interactive investor, notes that “among the more traditionally higher-paying income sectors are those heavily reliant on cash generation and strong capital positions, such as oil, banks and tobacco”.

He adds: “BP (LSE:BP.) and Shell (LSE:SHEL) currently yield 4.4% and 4% respectively, while HSBC (LSE:HSBA) yields 5.4%, Lloyds Banking Group (LSE:LLOY) pays 5.8% and NatWest (LSE:NWG) offers 6.7%. British American Tobacco (LSE:BATS) and Imperial Brands (LSE:IMB) have current yields of 9.4% and 8.3% respectively, and provide additional benefit due to their defensive nature. There are also some punchy yields within the insurance sector.”

As for the question of capital growth, the conventional wisdom is that bond prices tend to be less volatile than share prices. In other words, the capital value of your bond investments is likely to rise and fall less than that of your equity holdings. This isn’t always the case – indeed, the past few years have seen heightened levels of volatility in the bond market – but has been a rule of thumb over extended periods.

Inflation and interest rates key for both shares and bonds

The prospects for both bonds and equities right now are debatable. Much depends on whether the slowdown in inflation seen in recent months persists. If so, central banks may not need to raise interest rates further to any significant degree. That would be positive for the capital value of bonds, with yields easing back in anticipation of lower interest rates to come. It should also support equity prices, with fears allayed that rising rates could tip the economy into recession and hitting companies’ performance.

The less optimistic scenario from a capital growth perspective is that inflation once again begins to surge. We have already seen rising oil prices in recent months, for example, with political instability potentially accelerating that trend. In which case, interest rates may rise further, which would hit bond prices – and potentially equity prices too as economic growth is squeezed.

Stephen Snowdon, head of fixed income at the asset management firm Artemis, argues that these factors mean the dice is currently loaded in favour of bonds. “It has got a lot harder for equities to substantially outperform bonds in the current environment,” Snowdon argues. He adds: “There are so many headwinds and a serious risk that central bankers trying to kill inflation will kill the patient at the same time, sending the world into recession; that is likely to hurt equity portfolios more than a well-chosen portfolio of bonds.”

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However, not everyone shares that view. Laura Foll, co-manager of Henderson Opportunities (LSE:HOT) Trust, Law Debenture (LSE:LWDB) and Lowland (LSE:LWI) Investment Trust, sees things differently. “Maybe the best way to answer this question is to say where I’m putting my own family’s money, and that is largely in equities,” she says.

Foll adds: “I meet company management every week and while the market is particularly gloomy around the UK, I find it very difficult to tally that with what I hear at most of these meetings.

“Bonds have their place, but I don’t believe they offer the same opportunity as UK shares for a bounce in the capital in addition to the income.”

One other nuance to add here is that many companies in the UK have grown frustrated about the gloomy sentiment in the UK stock market. They have therefore been using earnings to buy back some of their shares, rather than paying this money out as dividends. In effect, that means many investors have been getting an extra slice of return that isn’t immediately visible in the dividend or share price.

If this continues for two or three years more then there is potential for remarkable transfers of value from disinterested sellers to patient shareholders, points out Nick Shenton, manager of the Artemis Income fund.

He adds: “We will either end up owning much more of the companies’ profits or we will benefit from a rise in share prices.”

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The bottom line? For immediate income, bonds now offer superior payouts to shares for the first time in many years. But looking to the medium or longer term, the merits of the two asset classes are much more finely balanced. Equities still offer the potential benefits of inflation protection for your income, as well as a capital performance that has historically been better.

In practice, many investors will want to continue to own both shares and bonds, with a balanced portfolio offering risk mitigation and the potential to benefit from both investment stories. However, you may want to consider shifting your asset allocation strategy. Traditionally, a balanced portfolio would often be invested 60% in shares and 40% in bonds. Increasing the latter percentage may now make sense – at the very least, you will be locking into bonds at today’s elevated levels of yield.