Is it time to get our taxable investment income from dividends instead of interest?

That question came to mind as I viewed the chaos of the fixed income markets following a more than 100 basis point rise in the 10-year Treasury yield. Suddenly yielding 4.5 percent, the 10 year Treasury has lead a nasty retreat in bonds. The average intermediate term government securities fund, for instance, has lost 2.5 percent in the last month and 0.45 percent year to date.

If we're at the beginning of the hoped for economic turn-around, yields could rise further. That means bond prices could fall more.

Then, as if Fear of Falling isn't enough, there's the tax angle.

Interest payments are taxed as ordinary income. That means tax rates up to 35 percent. Most dividends, on the other hand, now get a big tax break. They're taxed at 15 percent. The 20 percent difference gives dividends a big advantage.

To give you an idea of the new relationship between bond yields and stock yields I've built a table showing the pre-tax yields on Treasury securities from 6 months to 10 years, the after-tax yield (at 35 percent), and the pre-tax yield you need on a stock to provide the same after-tax income. Then I looked up the number of stocks offering a yield that high or higher.

As you can see, the 4.5 percent pre-tax yield on the 10-year Treasury becomes an after-tax yield only 2.93 percent. To have the same after tax yield a stock only needs a pre-tax yield 3.44 percent--- a full percentage point lower. There are 367 domestic (and non REIT) stocks in the Morningstar database (as of June 30) with that yield or better.

Since stocks also grow their earnings, a portfolio of stocks with high yields starts to look very attractive.

Stocks Whose Dividend Yields Compete with Bonds
This table assumes a 35 percent tax bracket for interest income and a 15 percent tax bracket for dividend income
Treasury Maturity Treasury Yield Treasury A.T.Yield Equiv. Pre-tax Stock Yield No. of Stocks
   6 month 1.01 percent 0.66 percent 0.78 percent 1,443
   2 years 1.81 1.18 1.39 1,189
   5 years 3.32 2.16 2.54      686
10 years 4.50 2.93 3.44      367
Sources:, 7/31/03; Morningstar Principia, 6/30/03 data

  A story from financial history takes us another step. In 1966 Fidelity created the Equity-Income fund, now one of its largest. Its stated goal was to hold stocks with a higher yield than the S&P 500 Index. In the years of the Nifty 50 market---1970 through 1972--- a period much like the recent Bubble Years--- the fund underperformed the market terribly.

Why? The so-called "Nifty 50" growth stocks were priced to ludicrous new highs and unbelievable P/E ratios. (Sound familiar?)

The fund trailed the S&P 500 by a total of more than 30 percentage points between 1970 and 1972.

Then we had the great crash of 73-74.

From 73' through 1984, a period of 12 years, Fidelity Equity Income trounced the S&P 500 index by an average of 9 percentage points a year. Needless to say, much of this was due to the skill of its former manager, Bruce Johnstone.

By the late 70's, portfolio theorists were fond of "yield-tilt"--- investing in stocks with a bias for yield.

What's interesting here is that Fidelity Equity Income trailed the S&P 500 by about the same margin in the 97-99 equity bubble as it did in 1970-1972 Nifty-50 market--- more than 30 percentage points--- but beat it through the 00-02 crash just as it did through the 73-74 crash.

In the late 70's, even as rising interest rates crushed stock P/E ratios down to 8 times earnings, Equity-Income fund continued to produce superior returns, as did most of the handful of equity-income funds then in operation. If patterns repeat--- and that's a very big "if"--- investors might do well to buy dividends and wait for them to grow.

Of the five largest no-load equity income funds (Fidelity Equity-Income I and II, T. Rowe Price Equity Income, Vanguard Equity-Income, and American Century Equity Income), the one with the best performance over the last 3 and 5-year periods is American Century Equity Income (ticker: TWEIX, minimum investment $2,500, expense ratio 1.00 percent).