10-Year Treasuries Yield 5.3%; Schwab's Dividend ETF Yields 3.4%. Which One Should Income Investors Buy?

Ten-year Treasury yields hit their highest level since 2002 at the start of the month. That's attracted a lot of attention from income investors. When you can receive a yield of around 5.3% guaranteed by the U.S. government after decades of extremely low interest rates, it's going to attract some attention.

Meanwhile, a soaring stock market means that, for the most part, dividend yields remain relatively low. The Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD), a favorite exchange-traded fund (ETF) among many income investors, sports a 30-day SEC yield of 3.4%.

So, should income investors prefer Treasuries over the Schwab ETF right now? Here's what you need to consider.

Image source: Getty Images.

Is dividend growth worth the risk?

The Schwab U.S. Dividend Equity ETF owns stakes in high-quality dividend growth stocks. These are all companies with solid balance sheets and strong free cash flow, supporting potential dividend increases for the foreseeable future.

That's backed up by its track record of increased dividend payments year after year. In 2012, the ETF paid $0.27 per share (split adjusted). Over the last 12 months, it paid $1.0541 per share. That's an annualized dividend growth rate of 9.7%. Over the last five years, the dividend climbed an average of 7.2% per year.

Of course, the ETF is full of stocks, and stocks tend to fluctuate in value. A Treasury bond, on the other hand, is practically guaranteed to return your entire principal if held to maturity.

The good news is that, because of the index's selection criteria, the ETF's constituents are all quality stocks. Quality stocks hold up better in market downturns than the average stock and participate in most of the upside.

Still, the Schwab ETF has consistently seen drawdowns of more than 15% (but less than 20%) in bear markets. It dropped as much as 33% early in the COVID-19 pandemic crash before recovering relatively quickly (along with the rest of the market). Nonetheless, the share price has climbed 132% over the last decade, leaving patient investors with more than twice their investment while collecting growing dividend payments each year.

The question for investors is whether the potential for higher dividend payments, compared to stable Treasury payments, is worth the risk of investing in equities.

A side-by-side comparison

If we assume an 8% annualized increase in dividend payments from the Schwab ETF versus stable payments from Treasuries, here's how the cash flows compare between the two investment vehicles on a $100,000 investment.

Source: Calculations by author.

Even with excellent growth, the Schwab ETF doesn't produce as much annual income as the Treasury bonds until year eight. Total income from the investment over 10 years falls well short. As such, investors who require more income in the short term should increase their weighting toward Treasuries now, especially since they'll be more insulated from market volatility (though bond prices can also decline).

But the income gap could be narrower (or wider) than it first appears due to how the government taxes dividends versus Treasury bonds. Qualified dividends are taxed at the same rate as long-term capital gains, usually 0% or 15%. Treasury bond interest is taxed as income at the federal level but is exempt from state income taxes.

If you live in a low-income-tax state or you keep your total income low, that tilts the numbers in favor of the dividend ETF when you consider how much you get to keep after taxes. If you live in a high-income-tax state, it may further tilt the numbers in favor of Treasuries.

The real question income investors have to decide is how much risk they want to take on and how much they value capital appreciation.

Over time, the Schwab U.S. Dividend Equity ETF should increase in value as the earnings of the quality companies in its portfolio grow year after year. After all, that's the fundamental driver of its growing dividend payment. But you're still subject to the market's whims and to how much it values those earnings and future cash flows. You might have to take a loss on your principal if you have unfortunate timing with capital needs beyond the dividend income it generates.

On the other hand, Treasury bonds will fluctuate in value up until maturity based on prevailing interest rates. But with expectations for interest rates to move lower from here over the long run, that should favor investors who don't expect to tap into their principal in the next two or three years. If held to maturity, you'll receive the entire principal back.

Investors with longer time horizons and sufficient capital outside of equities to handle unexpected expenses will likely do better investing in the Schwab ETF, but it's closer than it's been in a long time.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.