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June 30, 2013

The searchfor income: Dividend-paying stocks vs. bonds

Investors, especially retirees, often use their portfolios to generate income. With bond yields and interest rates on CDs and money markets at record lows, these investors are searching for alternatives to meet their income objectives. Spurred by the headlines in some of the popular consumer finance magazines, many of them are heading down what could prove to be a perilous path, trading their bonds for dividend-paying stocks and the mutual funds that invest in them.

On the surface, the idea of replacing low-yielding bond investments with blue chip stocks that offer not only a higher yield but also the potential for capital appreciation if stock prices continue to climb seems like a sensible move. However, upon closer scrutiny, the logic of this strategy contains some serious flaws. While both investments are used to generate portfolio income, savvy investors recognize that stocks, including those of dividend-paying, blue chip companies, are on opposite ends of the investment risk spectrum when compared to bonds.

Specifically, dividend-paying stocks are about four times more volatile and therefore carry four times the potential for loss than high-quality bonds. So, the strategy of substituting dividend-paying stocks for bonds to generate more income results in a more aggressive and less diversified portfolio.

High-quality bonds provide important diversification and stability to investor portfolios particularly during times of financial crisis when it is needed most. The most recent and starkest example of this is the 2008-2009 financial crisis. Between the stock market peak on Oct. 9, 2007, and its subsequent low on March 9, 2009, the portion of investor portfolios consisting of high dividend-paying stocks lost around 50 percent of their value while the portion consisting of intermediate term U.S. Treasuries gained almost 15 percent. Investors with equity heavy portfolios including those with dividend-paying stocks experienced steep declines and enormous emotional turmoil while those with balanced portfolios of stocks and bonds fared much better.

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