This feature was prompted by a reader question on why ‘bond proxies’ such as insurers Phoenix Group (PHNX) and Aviva (AV.) do not attract more investor attention.

A bond proxy typically refers to a company which has a steadier-than-average income stream and offers a higher-than-average level of income.

Long-term savings and insurance group Phoenix sits on a dividend yield of 10.4% based on an expected 2024 dividend per share of 53.9p while insurer Aviva sits on a forward yield of 7.3% based on an expected payout of 34.7p for 2024.

The reader asks why investors are not taking advantage of these ‘chunky’ yields when 10-year gilt yields have fallen close to 4% as investors anticipate interest rate cuts by the Bank of England.

NEED FOR PERSPECTIVE

Some perspective is useful here. When interest rates were virtually zero before the pandemic there was more incentive for investors to reach for higher yields and take more risk. Today, the situation is very different and there is less reason to take on the higher risk of investing in bond proxies.

Let’s compare some of the risks of investing in stocks for income rather than bonds.

The first point to consider is that government bonds are ultra-safe because they have state backing which means investors can confidently bank on receiving the expected annual income and getting their money back at maturity.

Dividends by contrast are discretionary payments rather than contractual, which makes them far less reliable for income.

While company managements are often wary of cutting dividends or paying too much in relation to annual profit, that is not the same as the iron-clad contract given by government bonds.

Unusually high dividend yields can be a sign that investors are not confident in the sustainability of the payout or on whether it will be paid at all. That said, an elevated yield can also signal a stock or sector is just out of favour.

NEED FOR GOOD JUDGEMENT AND ANALYSIS

Deciding whether a high yield is a so-called value trap, or a genuine investment opportunity requires good judgement and analysis. We discuss the merits of Phoenix shortly.

Another factor to consider is the different risk and return characteristics of stocks versus bonds. Stocks provide the potential for growth which bonds do not, if held to maturity. (Capital gains and losses can occur if a bond is sold before it matures).

The potential for stocks to grow is the main reason investors opt to own shares over bonds, notwithstanding stocks can also provide a growing income.

A rising share price, at some point, requires a growing earnings stream, if it is to be sustainable. Shares which rise without the underlying support of earnings are vulnerable to falling back down or inflicting capital losses.

Some businesses can grow faster than others. Slower growing companies generally payout a higher proportion of their profit to investors through dividends.

The reality is that there is a spectrum of growth and income, from low or ex-growth businesses to super-fast-growing ones like AI champion Nvidia (NVDA:NASDAQ) which does not pay any dividends.

What is important to investors is total return, whether that comes 100% via capital growth or a mixture of growth and income.

TAKING A CLOSE LOOK AT PHOENIX

Armed with the preceding context, let’s take a closer look at Phoenix to see where it sits on the growth and income spectrum.

Investors should expect stock prices to follow earnings over the long run, so it is not surprising Phoenix shares have tracked a languishing EPS profile over time. Over the six years before the pandemic, Phoenix’s EPS (earnings per share) fell from 75.2p to 68.6p according to Stockopedia data.

By contrast dividends per share have grown at a compound annual growth rate of 2.7% a year. The combination of a growing dividend and falling share price has created the current double-digit dividend yield. How sustainable is it?

Analysts are forecasting a 2024 dividend of 53.9p per share which is not fully covered by EPS of 46.9p. That is not necessarily an intractable problem if management expect a recovery in earnings which looks to be the case with forecast 2025 EPS growing 16% to 55.1p.

It seems fair to conclude that Phoenix sits at the lower growth, higher income part of the total return spectrum and deserves its bond proxy label given the steady growth in income.

Some investors may look favourably on the extra yield they can earn relative to government bonds and be happy to take on the extra risks. As ever, the decision comes down to individual risk appetite.

An important thing to understand is that low growth does not always mean low returns, if the starting dividend yield is high.

Reinvesting dividends is an important factor in generating the maximum total return.

In the case of Phoenix, a yield of 10% means an investor could double the value of their investment after around seven years, even if the share price remains unchanged (see table).

It might not be as exciting as watching a share price double in value, but a cash dividend is a ‘bird in the hand’ worth having.

The annual Barclays Equity Gilt Study shows more than half of the stock market’s total return (share price gains plus reinvested dividends) comes from dividends, underscoring how important this income stream is in generating wealth. 

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