Question: Are high-dividend-paying stocks 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 rising interest
rates could mean for bond prices, as 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
because of their often-high yields, and I have written about the
viability of preferred stock
for retiree portfolios. In addition to those more exotic
income-producing vehicles, some investors have also gravitated toward
plain-vanilla dividend-paying stocks.
It's easy to see the appeal. Some high-quality dividend-paying stocks
in the health-care, 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.
Despite these positive attributes, 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
For example, the 10-year standard deviation of the typical fund in
Morningstar's large-value category, where income-oriented stock funds
tend to reside, is 15.4, versus 4.3 for the average intermediate-term
bond fund. Large-value funds have also been more risky than notably
volatile bond-fund types such as junk-bond funds (average 10-year
standard deviation: 9.7) and emerging-markets bond funds (average
10-year standard deviation: 10.7). 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.
Moreover, dividend-paying stocks aren't looking quite as cheap as
they were a couple of years ago. Back in 2010, the typical
dividend-paying exchange-traded fund in Morningstar's coverage universe
was notably undervalued relative to our analysts' estimate of fair value
of its underlying securities, according to our ETF Valuation Quickrank tool.
But following a relatively strong run in dividend payers, most
dividend-focused ETFs look pretty fairly valued now, according to our
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