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Should You Pick Dividend-Paying Stocks Over Bonds?

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.

Talk to a Fixed Income Specialist at 877-566-7982. FIND A BRANCH

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.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Treasury Inflation-Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Interest payments on inflation-protected debt securities can be unpredictable. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

The S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Barclays U.S. Aggregate Bond Index covers the USD-denominated, investment-grade, fixed-rate and taxable areas of the bond market.

The Dow Jones Select Dividend Index seeks to represent the top 100 U.S. stocks by dividend yield. Stocks are selected to the index by dividend yield, subject to screens for dividend-per-share growth rate, dividend payout ratio and average daily dollar trading volume.

The Barclays U.S. Treasury Bond 3–7 Year Term Index measures the performance of government bonds issued by the U.S. Treasury. The Term Index methodology is a unique concept in bond indexing developed by Barclays. The benefit of the term methodology is that the term indices have similar yield, duration and risk/return characteristics to standard maturity-based indices but are more compact and tend to be more liquid than the equivalent maturity index, which also includes bonds issued at longer tenors and that have rolled down the yield curve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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