Why I prefer buying ASX dividend shares over bonds

I love investing in good businesses for income.

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ASX dividend shares are a popular way for people to invest – my portfolio has a number of passive income stocks in it. I'd much prefer to invest in ASX dividend shares over bonds for a number of reasons.

As a reminder, bonds are a form of debt that a company or government may issue to, for example, pay for a project. The investors usually get paid interest during the length of the bond term.

There are three reasons why I prefer ASX dividend shares over bonds, which I'll now explain.

Stronger yield potential

Bonds are now offering investors a stronger yield thanks to the higher interest rate environment by central banks such as the US Federal Reserve and the Reserve Bank of Australia (RBA).

For example, at the end of August, the Vanguard Australian Government Bond Index ETF (ASX: VGB) had a yield to maturity of 4.07% and the Vanguard Australian Fixed Interest Index ETF (ASX: VAF) had a yield to maturity of 4.2%. We'd have to look at 'riskier' countries and businesses to get a materially better income return.

A yield of 4% is not bad at all, but with ASX dividend shares we can get much better yields, particularly if franking credits are involved.

For example, in FY23, Telstra Group Ltd (ASX: TLS) paid a grossed-up dividend yield of 6.3% and Bunnings and Kmart owner Wesfarmers Ltd (ASX: WES) paid a grossed-up dividend yield of 5.1%. These are the sorts of businesses that could be around for many years to come.

Better capital growth potential

When a bond term ends, investors are meant to receive the value of the bond back. For example, if the bond has a principal amount of $100, they're meant to get $100 back at the maturity date. To me, that limits the amount of capital return potential, aside from interest rate changes. Any valuation benefits that interest rate cuts give bonds should, theoretically, also help the valuation of ASX dividend shares.

Investors may be able to buy a bond at a discount to its underlying value, but the underlying value isn't really going to change.

With (good) ASX dividend shares, we're hoping to see profit growth as they deliver on growth plans, benefit from population growth, increase prices, or however else they plan to grow earnings.

Profit is one of the main ways that investors value a business, and long-term profit growth can send the share price higher over time.

For example, in the last five years, we've seen the Wesfarmers share price lift around 50%, the Telstra share price has gone up more than 20% and the Washington H. Soul Pattinson and Co. Ltd (ASX: SOL) share price has climbed 32%.

Income growth

Profit growth can help grow the income payments to shareholders. Bonds typically offer investors a fixed level of interest income, so there's no organic growth potential there.

I like businesses growing profit because it means that investors can get a combination of growing dividends and hopefully share price growth.

For example, in the latest result, Telstra grew its annual dividend per share by 3% and Wesfarmers increased its annual dividend per share by 6.1% to $1.91.

Motley Fool contributor Tristan Harrison has positions in Washington H. Soul Pattinson and Company Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Washington H. Soul Pattinson and Company Limited and Wesfarmers. The Motley Fool Australia has positions in and has recommended Telstra Group, Washington H. Soul Pattinson and Company Limited, and Wesfarmers. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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