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Can Dividend-Paying Shares Replace Bonds?

Even if you think interest rates are going up, don't swap your whole fixed-income position for dividend-paying stocks

Christine Benz 29 January, 2013 | 4:00PM

Question: 2012 was the year of the bond fund and talk of a bond bubble, particularly in emerging market debt, resurfaced once again throughout the year. For investors looking for something different, can high-dividend-paying stocks be a decent proxy for bonds if you think interest rates are going up?

Answer: Possibly, but only in small doses, particularly if stability of your principal is as big a goal for your fixed-income portfolio as is current income.

It's easy to see the appeal of dividend-paying stocks versus bonds. For one thing, bond yields are downright depressed because of a stampede into fixed-income assets during the past few years: Investors are also rightfully concerned about what a sustained period of raising interest rates could mean for bond prices. (A new supply of higher-yielding bonds will tend to depress the prices of older, lower-yielding bonds.)

Due to that unattractive convergence, I've been hearing from a lot of investors who have become interested in master limited partnerships (MLPs) because of their often-high yields, and we have previously written about the viability of preferred stock for retiree portfolios. In addition to those more exotic income-producing vehicles, some investors have also gravitated towards plain-vanilla dividend-paying stocks.

It's easy to see the appeal. Some high-quality dividend-paying stocks in the healthcare, telecom and utilities sectors have yields of 2%, 3%, 4%, or even more, making them competitive with bonds on a yield basis alone. Moreover, these stocks generally have greater capital-appreciation potential than do bonds and bond funds. For bond-fund investors, by contrast, yield usually forms the lion's share of any total return you pocket.

Tax treatment is another point in favour of dividend-paying stocks. In the UK, dividends (whether ordinary, preference shares, or from unit trusts and open-end companies) are treated at different rates from other income. Check the DirectGov website for the most up-to-date rates information.

Due to all of these positive attributes, dividend-paying stocks could work well as a component of a portfolio that would otherwise be devoted to fixed-income securities. At the same time, however, I'd caution against going overboard with such a shift. The key reason is volatility.

It's true that dividend payers tend to be less volatile than non-dividend-paying stocks. The former's ability to pay a dividend is an important show of financial wherewithal, and having a dividend yield also provides at least a small cushion against losses. Yet dividend-paying stocks' volatility profile is substantially higher than is the case for bonds. Given that many fixed-income investors are looking for stability of their principal as much as they are for current income, that means a big slug of dividend payers could be a mismatch in retiree portfolios.

For example, the typical equity-income fund in Morningstar's database has a 10-year standard deviation of 15.2, versus 4.3 for the typical intermediate-term bond fund. Equity-income funds have also been more risky than notably volatile bond-fund types such as junk-bond funds (average 10-year standard deviation: 10.2) and emerging-markets bond funds (average 10-year standard deviation: 11.5). In a nutshell, you can venture into some pretty risky bond types without getting close to the volatility profile you'd have with a basket of dividend-paying stocks.

True, bonds have had a tremendous run during the past few decades, so it's unlikely that their volatility profile going forward will be as placid, particularly if interest rates go up. At the same time, however, equities wouldn't necessarily be impervious in the face of rising interest rates, though the cause-effect relationship isn't as direct. There are a couple of reasons why. First, rising interest rates mean increased borrowing costs for consumers and businesses, which in turn affects the ability of companies to grow and expand. Second, as interest rates on newly issued fixed-income securities trend up, bonds and cash become a more attractive alternative to stocks, and decreased demand could depress stock prices.

Despite all those caveats, I still think dividend-paying stocks can be a sensible addition to retiree portfolios, for the reasons I outlined above. But if stability is as big a concern for you as is current income, you're better off thinking of dividend-payers as a way to tweak your equity portfolio rather than to supplant your fixed-income holdings.

A version of this article appeared on Morningstar.com on Jan. 27, 2011.

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About Author Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.