Bonds are an important part of any investment strategy. As your time horizon shortens, bonds can be used to reduce the volatility (which should always be read as another word for “risk,” by the way) of your total portfolio. The trade off for this, of course, is that bonds offer lower potential returns than stocks.
Bonds provide interest income, which is taxed at the ordinary income rate, so taxable bonds are best held in a tax-deferred account like an IRA or 401(k) plan.
It’s easier to stomach the lower return of your bond portfolio when yields are high and interest rates are rising, since the absolute numbers are higher. The market disasters of recent memory have increased our tolerance for returns in the 5-7% range, since many of us feel lucky to be getting that much. But when rates are falling and bond yields drop, we sometimes find ourselves getting restless.
The silver lining to a low rate environment?
Enter the seemingly perfect solution – the dividend-paying stock. Like bonds, dividend-paying stocks offer income potential in the form of dividends, usually paid quarterly. However, since they stocks, dividend-payers offer greater return potential than bonds. In fact, dividend-paying stocks tend to outperform non-dividend payers over the long term.
Dividends also have tax advantages over the interest payments offered by bonds. For 2015, the tax rate for dividends is 15% (for all except those earning very high incomes) – the same as the capital gains rate. For this reason, dividend-paying stocks offer greater tax efficiency in a taxable account.
A dangerous strategy
If something looks too good to be true, it probably is, right? In this case, the answer is yes, unfortunately. Replacing taxable bond holdings with dividend-paying stocks may or may not pay off in the short term. But as a long-term strategy, it could end very badly.
A bond is a legal obligation in which the issuer agrees to pay interest in return for the loan. A dividend-paying stock, however, includes no such obligation. Certainly there are stocks that historically, have somewhat reliably paid dividends (that’s why dividend-paying stocks are a category), but there are no guarantees. As with all things performance-related, the past should not be used to predict the future.
Dividend stocks offer higher return potential than bonds, it’s true, but the overall performance numbers don’t tell the whole story. Dividend stocks come with all the volatility of an equity asset class. Swapping out bonds for stocks – any stocks – doesn’t make sense as an overall strategy, since the swap sacrifices the stability the bonds were meant to bring to the portfolio in the first place.
And that higher return potential? It’s not quite that simple. Historically, dividend stocks have outperformed other stocks, it’s true, but in a rising interest rate environment, dividend stocks tend to do poorly as bond yields catch up.
As to the impact of dividends on your tax bill, it should be abundantly clear that the negatives outweigh any potential gains there. Additionally, the tax code can be a fickle thing, and a change in tax law could wipe out this advantage at any point.
Stay the course
None of us likes to feel like we’re missing out, and watching other areas of the market do well can color our view of the less volatile portions of a portfolio. But those allocations are the bedrock that provides a measure of stability to offset stock market swings. Remember that – and let your bond allocations do their job.