At first glance it may look like a win-win proposition. Trade the paltry income your bond portfolio is generating for the higher yields of dividend-paying stocks, and you can have more income today—plus the potential for capital gains down the road.
But looks can be deceiving, says Kathy Jones, vice president and fixed income strategist at the Schwab Center for Financial Research. “Stocks and bonds play very different roles in a diversified portfolio,” she says. By loading up on stocks—even dividend payers—you could be adding some unintended risk to your portfolio.
So before you fall for an attractive yield, consider these four factors:
Reliability of income. Dividends are paid at the discretion of the board of directors—which can raise, lower or eliminate a dividend whenever it chooses. “Your dividend is not legally binding for the company paying it,” Kathy says.
In contrast, a bond is a loan to the corporation or public entity that issues it (some bonds are secured, but most aren’t), and the issuer is required by law to repay it. Barring default, your coupon payment should remain the same as long as you hold the bond.
Stability. You know that stocks are more volatile than bonds. In fact, according to the Schwab Center for Financial Research, stocks in the S&P 500® Index have been four times more volatile than the Barclays Aggregate Bond Index during the past 20 years.
That’s why, in periods of economic uncertainty, investors can be quick to dump stocks and seek shelter in bonds. For example, between the market high in October 2007 and its low in March 2009, the Dow Jones U.S. Select Dividend Index lost about 54% of its value. During the same period the Barclays 3–7 Year Treasury Bond Index gained more than 14%.
Diversification. One common strategy for managing market volatility is to hold a combination of stocks and bonds in your portfolio because they tend to move in opposite directions. “Bonds usually do well when stocks don’t,” Kathy says. “So while it’s fine to have dividend-paying stocks in an equity allocation, they shouldn’t be a substitute for a bond allocation.” Remember, if you trim your bonds now, you won’t have as much insulation against a potential downturn in the stock market down the road.
Interest-rate risk. “People forget that if something is attractive because of its yield, chances are when interest rates change that security will perform a lot more like a bond than a stock,” Kathy says. When interest rates move up, high-dividend-paying stocks (particularly utilities) could take a price hit because, like bonds, they’re more sensitive to interest-rate risk.
That’s not just conventional wisdom. Kathy and her fixed income team examined 10 periods in the past 20 years in which 10-year Treasury yields increased by at least one percentage point in 18 months or less. They found that during those periods, the S&P 500 posted an average total return of 9.7%. Utility stocks, on the other hand, lost an average of 3.6%—slightly underperforming the Barclays U.S. Aggregate Bond Index, which lost an average of 3.3%.
In other words, pursuing higher yields through dividend-paying stocks doesn’t guarantee that you’ll get the best of both worlds—especially in a rising-rate environment. “Stocks are stocks, and bonds are bonds, and investors shouldn’t mix up the two,” Kathy cautions.