Dividend Stocks Are Hot, But They Aren’t Bonds

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The search for retirement income in today’s low-yield environment inevitably comes back to dividend paying stocks. How could it not? Money market funds and short-term bank CDs pay about .5%; the 10-year Treasury bond pays only about 2%.

Lots of blue chip stocks pay significantly more, including Verizon (5.3%), Merck (4.4%), Pepsico (3.1%), Lockheed Martin (4.7%), Intel (3.1%) and Abbot Labs (3.5%). In fact, the average dividend yield for stocks in the S&P 500 is above 2%–higher than the venerable T-bond. That’s crazy. For most of the past 50 years, the T-bond’s yield has been at least double what you could get by owning a basket of S&P 500 stocks.

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The financial world is upside down. Investors were clearly buying stocks for income last year, when they poured $17 billion into equity income funds even though stock funds as a group saw outflows of $80 billion.

To help retirees secure an income stream without assuming stock risk, the government is backing deferred annuities as a 401(k) investment option and planners are recommending immediate fixed annuities along with a strategy of delaying Social Security benefits to age 70 in order to get a higher monthly benefit. Other income strategies include tilting toward higher yielding corporate and international bonds.

No matter how you cut it, though, dividend-paying stocks usually end up in the conversation. So it’s worth reminding yourself that even blue chip multinational stocks are, well, stocks. They are far more volatile than bonds, meaning that the market value of stock holdings swings higher and lower in a much broader range. You could easily have a year’s worth of dividend payments wiped away by a declining share price if you sell before the stock recovers.

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The Wall Street Journal made this point forcefully with a graph that accompanied a story titled, “Why Dividend Stocks Aren’t The New Bonds.” Charting the value of all stocks, dividend stocks, and bonds over the past year, you see that dividend stocks closely track all stocks while the bond market rolls along in steady-eddy fashion.

Still, in a low-yield world blue chip dividend payers have special appeal, particularly for investors who will not have to draw down their account over time but can make ends meet simply by cashing their dividend checks each quarter. Income seekers drawn to stock dividends can minimize risk by:

  • Diversifying income source In the Journal story, planners recommended no more than 70% of an income portfolio in dividend stocks; the rest should be in bonds.
  • Watching costs A mutual fund that charges a management fee equal to 1% of assets effectively reduces a 3% yield to just 2%. Why not just buy a 10-year Treasury bond if 2% is enough? Find an equity income fund or exchange-traded dividend fund that charges less than .5%.
  • Understanding stock volatility If you cannot stomach your principal value falling by 20% in the near term, you should not be seeking income through the stock market. If you are diversified and patient, near-term swings don’t matter. What counts is that your portfolio or fund rises over time and the companies of stocks you hold raise their dividend every year.