Dividend Payers Hold Appeal, but Be Mindful of Risks

More than 1,500 Morningstar.com Premium subscribers participated in my recent Web seminar, entitled "Morningstar's Best Ideas for 2010 and Beyond." (Premium users can watch a replay by  clicking here; free members, learn more here.) I also received many terrific questions during and after the Web seminar, including this one about the appropriateness of dividend payers as a substitute for bonds.

Question: Are high-dividend-paying stocks a decent proxy for bonds if you think interest rates are going up?

Answer: Yes, 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.

Given currently paltry bond yields--just 3% or 4% for high-quality intermediate-term bond funds and 2% or even less for most short-term funds--I can see why income-focused investors would want to cast a wider net. 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 because of their often-high yields, and I recently wrote 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. PIMCO's Bill Gross began talking up dividend payers, specifically utilities and telecom names, in mid-2009, noting that he had added some of these stocks to his personal portfolio.

It's easy to see the appeal. Many high-quality dividend-paying stocks in the financials, 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. Based on our stock analysts' estimates of the fair value of their underlying holdings, many dividend-focused exchange-traded funds appear to be roughly 10% undervalued right now, according to Morningstar's ETF Valuation Quickrank tool. Given that our analysts think that their coverage universe as a whole is pretty much fairly valued right now, that's nothing to sneeze at. For bond-fund investors, by contrast, yield usually forms the lion's share of any total return you pocket.

Tax treatment is another big point in favor of dividend-paying stocks. Through next year, investors in tax brackets of 25% or above will pay just 15% on qualified stock dividends, and those in the 10% or 15% tax brackets will pay nothing. Bond income, by contrast, is taxed at the investor's ordinary income tax rate, which can range as high as 35%.

Due to all of these positive attributes, I noted in the Web seminar that 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, versus 4.4 for the typical intermediate-term bond fund. Equity-income funds have also been more risky than notably volatile bond-fund types like junk-bond funds (average 10-year standard deviation: 10.5) and emerging-markets bond funds (average 10-year standard deviation: 11.3). 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.

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