With interest rates on the decline, bond investors have seen (or will soon see) a drop in their income. Not that this is a new phenomenon; we experienced historically low yields just a few years back, but we are now seeing some investors and advisors engaging in a risky strategy to bolster income. This strategy involves replacing the bonds in the portfolio with high dividend paying stocks. With 10 year Treasuries and high quality corporate bonds yielding less than 2%, it is easy to see why these dividend paying stocks, with yields around 4%, are a lure. So far this year dividend focused stock ETFs have seen cash inflows increase from $5 billion last year to $12 billion to date in 2019.
However, while the dividends may increase income, swapping high quality bonds for stocks increases portfolio risk. The volatility of intermediate term high quality bonds is a third that of dividend paying stocks. In addition, many investors buy bonds not simply for yield, but for protection against equity risk. Purchasing high dividend paying stocks does not reduce this equity risk. Should the stock market correct, these stocks will decline as well.
It’s not that we are against dividend paying stocks. As a matter of fact, we introduced our own equity income strategy a few years ago based on research we conducted with our partner at Gonzaga University. That strategy currently provides a yield above 4.5%, and we believe it offers investors a long-term return that is competitive with the S&P 500. However, this strategy, like all other dividend income strategies, does not highly correlate with the movements in the S&P 500. Therefore, this strategy is not a good fit for investors wishing to peg their returns to the returns of the S&P. As a result, we believe this strategy is appropriate for a limited number of investors – investors who desire more income from their stock portfolio and are not worried about tracking error with the S&P. Needless to say, this group does not include investors looking to switch out of their bonds and into these stocks.
The lesson here can be summed up by a Latin proverb: caveat emptor, or let the buyer beware. Before selling out of low yielding bonds in pursuit of income gains, make sure you understand the risks. Often, when an investment seems too good to be true, it is. High dividend paying stocks can be great investments, for the right investor; but, like all investments, they come with inherent risk. When compared to high quality bonds, the risks are generally higher.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.