Are dividend stocks a good substitute for bonds?

The low interest rate environment we have experienced in recent years has been difficult for income-oriented investors. Traditional sources of income, such as certificates of deposit (CD), money market funds, and bonds, cannot provide the level of yield that many investors seek. There are many newsletters and articles describing the benefits of dividend-paying stocks. Of course, the types of companies that pay dividends and the mutual funds and exchange-traded funds (ETFs) that invest in these companies have their advantages. However, investors seeking income need to understand that investing in dividend-paying stocks is different from investing in bonds. Financial advisors working with clients need to ensure that clients understand these differences.

Different risks

Companies that pay dividends are still stocks, not bonds. Although many of these stocks, especially those that continue to pay dividends, may have lower volatility than some other stocks, they are still affected by many factors that affect the entire stock market. Take 2008 as an example. The Standard & Poor’s 500 Index fell 37% that year, while the Barclays Aggregate Bond Index rose 5.24%.

Let’s look at dividend-oriented ETFs. Vanguard Dividend Appreciation ETF (VIG) fell less than the Standard & Poor’s, but it still fell by 26.63%. The ETF focuses on high-quality large-cap stocks with a history of dividend growth. Vanguard High Dividend Yield ETF (VYM) pays more attention to yield, which fell by 32.10% in 2008. Although the performance of these two ETFs outperformed the S&P 500, a loss of this magnitude can be devastating for income-oriented investors, especially retirees. Is 2008 an extreme example? Yes, that’s right. Looking to the future, will bonds stick to it in the face of rising interest rates? Maybe not, but historically, even in the worst-case scenario, the volatility of bonds is much lower than that of stocks.

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Another example of a flawed reliance on dividends is Exxon Mobil Corporation (XOM). The stock closed at nearly $104 per share in mid-June 2014. The stock is currently trading at less than $75 per share.People who held 100 shares during this period received a dividend of $499 and lost approximately $2,900 in investment value.

Guaranteed

Going back to the day when the interest rates of money market funds and CDs were in the 4% to 6% range, fixed-income investors could obtain substantial returns and reasonably expect to retain most of their capital and live on interest. Today, money market interest rates are close to zero, and the interest rates of other instruments are at historically low levels. It is unrealistic for retirees or other income-oriented investors to expect to live on interest without using their capital. Investors seeking income need to move further away from risk. Options may include high-yield bonds, certain closed-end funds, preferred stocks, and dividend-paying stocks.

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These and other options generally carry greater risk than traditional bonds or money market instruments. Some fixed-income annuities can also be considered, but low interest rates will also affect their returns.

No guarantee

Dividends on common stocks are set by the company. Although companies generally like to maintain their dividend payout rates, there are no guarantees here. The company may encounter cash flow problems or decide to use some of its cash to fund internal growth.

Total returns and benefits

Perhaps a better way than focusing on the rate of return is to focus on the total return of the portfolio. The total return considers both appreciation and gains. Especially for retirees, total return may be a better choice than taking on more portfolio risks in an attempt to obtain additional benefits. Today’s retirees can expect to live longer than previous generations, and most people need to get a certain degree of growth from their investment to ensure that their life span does not exceed their money. Even for young investors, this approach makes sense.

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For retirees, part of their investment portfolio can be allocated for different purposes. The first part will provide funding for this year’s expenditure requirements, perhaps two to five years. This part of the investment portfolio will be cash or cash equivalents. The next section will cover dividend-paying stocks and other income-generating and moderate-growth types of instruments. Of course, any cash flow from this part of the portfolio can be used to supplement the cash portion. The last part of the portfolio will be used for growth. This will include stocks and other growth-oriented tools to help ensure that the portfolio owner does not exceed his or her money.

Bottom line

This is a difficult time for investors seeking income. Some publications and consultants have suggested that dividend-paying stocks are an alternative to more traditional fixed-income instruments. The fact is that dividend-paying stocks are still stocks, and their risks exceed most fixed-income instruments. Financial advisors can help clients who are trying to solve this problem find ways to achieve their goals while taking risks that they can accept.

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