Diary of a Dividend Diva: The Delusion of 'Safe' Bonds

 | Aug 20, 2013 | 8:00 AM EDT  | Comments
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Stock quotes in this article:

DVY

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tlh

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tlh

Many individual investors I speak to, especially retired folks, bemoan the lack of income in today's interest-rate environment -- yet they also bemoan the risk associated with owning dividend stocks in order to increase their yield. This argument certainly holds theoretical appeal, since bonds are supposed to be relatively "safe," while equities are relatively risky. However, as Yogi Berra once said, "In theory there is no difference between theory and practice. In practice there is." 

For some reason, most individual investors assume their principal is "safe" in bonds because of the guaranteed payback and ability to hold them to maturity. In practice, most investors own fixed income through bond funds, and fund managers are not paid to passively hold bonds -- they actively trade them, and rarely hold them to maturity.

So, in reality, bond fund net asset values fluctuate, sometimes wildly, in reaction to interest-rate changes. If an investor is experiencing principal volatility anyway, and may have to "lock in" losses if a fund sale is necessary, why not acknowledge the risk and realize that you are being paid almost nothing to take it? In contrast, equities may be equally volatile, but here you are capturing far more income, and have far more upside potential due to the growth of the underlying businesses. 

For instance, take a look at the performance of the iShares Dow Jones Select Dividend (DVY) compared with an ETF that holds 10-year US Treasuries, the iShares 10-20 Year Treasury Bond (TLH). Once rates started rising in May, the TLH got clocked, and you would have been down 7% in this "safe" bond investment. Meanwhile, the DVY has risen 15% year to date. The DVY also declined for a period in the spring, but it then rallied due to the underlying equity foundation, whereas the TLH has just kept getting crushed.

DVY vs. TLH -- Year-to-Date 2013
Source: Yahoo! Finance

To emphasize the point, look at the performance over the last two years. The TLH put up modest returns at best, at its peak being up 5%, whereas the DVY had returned you 45% at the peak, and is still up in the mid-30% area. The folks sacrificing income for "safety" got neither!

DVY vs. TLH -- Two-Year Chart
Source: Yahoo! Finance

Now, you can't be a good investor without examining the bear case to any argument, so we must concede that equities always carry risks, and the person swapping out of fixed income into stocks must be aware of that. In fact, under very dire circumstances, such as the Great Plunge of 2008 to 2009, even the dividend stocks can be crushed. The five-year chart below shows that the DVY performed as poorly as the overall market -- down 45% at its worst -- while the TLH held its ground. The DVY needed the full five years to recover.

DVY vs. TLH -- Five-Year Chart
Source: Yahoo! Finance

If you expect another rout such as the 2008-to-2009 debacle, then ignore this advice. If you expect garden-variety corrections, but not an exceptional decline, and you need income, then the swap into dividend stocks may be for you.  

If you really want to turbocharge your income, consider dividend-capture trading to boost your return -- while using only stocks with average yields and average risk. My dividend-capture partnership is up more than 25% this year, compared with that 15% total return of the DVY. Approximately 10% of that return is likely to be paid out in distributions, compared with yield of just 3.4% on the DVY. That's not a bad bargain, in my opinion.

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