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Bonds have always been touted as the vehicle for the more conservative investor. For years, basic financial planning advice has included the addition of bonds (also called “fixed-income” investments) in some sort of proportion relative to the investor’s age: the older you are, the more bonds you should have in your portfolio.
One common and easy-to-implement tactic advised you to have the same proportion of bonds as your age. So, if you were 30 years old, you would make sure that your portfolio was 30% bonds, and 60% other (presumably riskier) investments, including stocks. When you got to age 60, you would have 60% bonds, and so on. This was believed to make your portfolio more stable and less prone to loss than a portfolio that was made up completely of stocks.
Bonds generally act differently than stocks, so including them in your portfolio is considered a way to mitigate any sharp drops in the stock market. While stocks are doing well, however, the bond part of a portfolio will drag down the total returns.
For the past few years, conservative and income investors who have loaded up on bonds have been extremely disappointed by low interest rates. Yields on bonds and other “fixed-income” investments like CDs and money market funds have been extraordinarily low; they have been so low that they barely have kept up with inflation.
However, despite these low yields, the bond market had one of its best years in recent history in 2012. Over $300 billion went into bond mutual funds, and over $122 billion was withdrawn from stock mutual funds. Investors are still wary of stocks because of the 2008 recession, and sometimes these fears longer long after the situation warrants.
Stocks actually did far better than bonds in 2012, as the S&P 500 increased by 13.4%. Bond investors, however, saw gains of less than 5%.
In August, the Pimco Total Return Fund, the largest bond fund in the world, saw investor redemptions of nearly $8 billion. The fund has lost $41 billion in assets in the past four months, as Treasury rates have risen from under 2% to the current yield of 2.98%. As the interest rate has risen, the price of bonds declines, so this rapid increase in yields has meant terrible losses for many investors.
Because bond yields are on the low side relative to historical returns, the risk-reward ratio is out of whack. At this point, there is less chance of yields falling further (and consequently, prices rising) and more room for yields to rise and prices to fall.
While an investor who buys into individual bonds with the intention of holding them to maturity can ignore day-to-day or even year-to-year price swings and concentrate only on the actual yield, most investors purchase bond funds. The prices of the bonds in the fund’s portfolio therefore matter, and it’s hard for an investor to hold on through declines, as shown by the Pimco redemptions this year.
Since it is unreasonable for a bond investor to ignore price and potential loss, and focus solely on the interest rate that he is earning, a prudent investor might consider dividend-paying stocks as an alternative to bonds.
Like bonds, a dividend stock pays a distribution that rises or falls with the price of the stock itself.
However, dividend stocks have a number of benefits that make them better than bonds.
Dividend-paying stocks have historically been the best-performing segment of the investing market. They have outperformed bonds as well as non-dividend-paying stocks, in both bull and bear markets. In bear markets, they tend to fall less than the stock market overall (but not as much as bonds) and in bull markets, they tend to vastly outperform the broader stock market.
Source: BlackRock, Dividends Through Thick and Thin
Secondly, dividend-paying stocks tend to have lower volatility than the broader stock market. The dividend payment adds to the capital gains and increases the total return in the case of a bull market, and mitigates the loss in the case of a bear market.
Thirdly, stocks that pay dividends tend to raise them. While a bond’s payment is fixed, hence the term “fixed-income”, dividends can and are raised frequently by the companies that issue them. Bond coupons are determined at the time of issuance, and they never change. But if you choose your dividend-payers carefully, you can expect that your dividend will rise over time.
And, because they are stocks and not bonds, you can also expect capital appreciation at the same time as you can expect dividend appreciation. This goes back to the “outperform” quality. In particular, stocks that pay and raise their dividends every year (there are many that have lengthy histories of consistently raising their dividends) have outperformed all other categories of stocks in the long run.
When you evaluate dividend-paying companies for inclusion in your portfolio, make sure to look at the historical Dividend Growth Rate (DGR) in addition to the current yield of the stock. A 5-year DGR of 15% means that the dividend has actually doubled over the past 5 years. While this is no guarantee that the company will continue to raise its dividend at such an aggressive pace, it’s a great indicator that management is dedicated to returning money to shareholders.
You also want to look at the number of years that the company has been raising its dividend. There are many lists of such, including the Dividend Aristocrats list that is maintained by Standard & Poor’s rating service.
Once a company makes it onto such a list, it is reluctant to have to cut, or even freeze, its dividend and be pulled off the list. Some companies have dividend history going back 40 or 50 years. For those companies, you can be fairly sure that they will continue to pay and raise their dividends for years to come.
There are other criteria that you should consider when choosing a company for your portfolio, and I outline them here.
For my money, dividend-growth stocks represent the best opportunity, no matter how old you are.