One of the recurring themes in the financial press in recent years is a warning to income-oriented investors not to pile into dividend-paying stocks to boost portfolio income. The Wall Street Journal has a recent article on this topic titled, “Why Dividend Stocks Aren’t the New Bonds.” This article is motivated by the fact that $17 billion flowed into equity-income funds in 2010 even as $80 billion flowed out of U.S. equity funds.
The arguments made by the WSJ article are similar to those in a November 2011 blog post by Vanguard’s Chief Economist, Joe Davis, titled "Dividend-Paying Stocks Are Not Bonds.” Similar thinking on this topic can also be found in a 2010 article by Larry Swedroe, a well-known advisor and financial columnist, titled “Why a High-Dividend Stock Strategy Isn’t a Good Approach.”
The main implication of these articles is that investors are simply chasing yield and are moving money from low-yield Treasury bonds into higher-yield dividend-paying stocks. This may be true, but there are some ideas that show up quite frequently in these debates over the relative merits of dividend stocks vs. bonds that do not get sufficient attention.
A central theme of these articles is that investors do not understand that dividend-paying stocks are (in general) riskier than bonds, and that simply looking at yield is likely to lead them into ramping up the risk levels in their portfolios. This concern is certainly valid. As I show below, dividend stock funds tend to be much riskier than intermediate government bond funds. There is, however, a crucially important point that seems to get lost in this discussion: With the yields on Treasury bonds as low as they are, there are very rational reasons to adjust allocations to reduce the exposure to Treasury bonds and increase exposure to dividend-paying stocks.
I explored this topic in a previous Portfolioist post titled, “Burton Malkiel: Buy Munis, Foreign Bonds and Dividend Stocks,” which was based on a December Op Ed piece by Burton Malkiel. Malkiel, who may be largely credited with providing the intellectual foundation for simple indexed portfolios, proposes that the current state of the market is so extreme that traditional bond allocations need to be reconsidered. In particular, he believes that the yield of Treasury bonds is so low that the long-term inflation-adjusted yield on these bonds is likely to be negative, and proposes that municipal bonds and dividend-paying stocks should see increased allocations, while Treasury bonds should see their allocations reduced. Not surprisingly, Malkiel’s position was denounced by index fund purists who believe that such a change in basic asset allocation smacks of market timing.
To really think through the idea of substituting income asset classes for all (or part of) a Treasury bond allocation, it is crucial to compare both the yields and risks of possible asset allocations. By way of example, I have selected a number of ETFs that represent different parts of the income-generating asset universe (see table below).
It is straightforward to obtain the yields for these ETFs. It is also simple to obtain the historical risk levels of the individual ETFs (from Morningstar, for example). Calculating the historical volatility of a portfolio is a little harder, and calculating a forward-looking simulation of risk is considerably more involved. In the table below, I have compiled these figures for a number of alternative portfolios.
The first ‘portfolio’ is 100% allocated to an intermediate Treasury fund (IEF). This ETF has a 2.5% yield as of this writing and historical and projected risk levels that are very similar. What does 7% volatility mean? My standard rule of thumb is that you can lose roughly twice the volatility in a plausible ‘worst case.’ So, with IEF you are getting paid 2.5% in yield and may face roughly 14% - 15% in losses in a really bad 12-month period. The most recent Consumer Price Index data shows a 12-month change of 3%, so the yield of this fund is below the rate of inflation.
An investor who allocated 1/3 of his money into each of the three representative dividend-oriented stock funds (DVY, SDY, and VIG) would end up with a higher yield (2.9%) but a vastly higher risk level, with historical volatility of 16.8% and projected future volatility of 17.9%. In other words, such a portfolio has slightly higher yield than the Treasury fund but more than twice the risk. This hardly seems like a good tradeoff. I would imagine that this sort of simple-minded substitution is what authors are warning against. This is not the whole story, however.
The third sample portfolio in the table above is a simple combination of 20% allocated to dividend stocks (DVY), 40% allocated to investment-grade corporate bonds (LQD), and 40% allocated to a national insured municipal bond fund (PZA). This portfolio has 4.1% yield, markedLY higher than that of the Treasury fund, and also has less risk than the Treasury fund on a trailing and forward-looking basis. Even if we are willing to raise the maximum risk level of our model portfolio to 7.7% (the projected volatility for a 100% allocation to IEF), there is no allocation to Treasuries that will raise the yield of this portfolio.
It is important for anyone contemplating this type of substitution to understand that while the risk levels of the portfolio yielding 4.1% above is similar in magnitude to that of the intermediate Treasury index, the sources of risk are different. The returns from IEF have a -98% correlation to the 10-year Treasury yield. All of the risk in IEF is interest rate risk. In the portfolio that mixes dividend stocks with muni bonds and corporate bonds, the return has only a -9% correlation to the 10-year Treasury yield. The risk in this portfolio is a combination of interest rate risk, corporate default risk, municipal default risk, and market risk.
What these results demonstrate is that while it is correct that simply replacing bonds with dividend-paying stocks is quite likely to result in a massive increase in portfolio risk, there are intelligent arguments which support investors scaling back on their allocations to Treasury bonds and adding allocations to dividend-paying stocks. The key to this process is to properly balance risk vs. yield.
I deeply hope that there are not a lot of investors who sell Treasury bonds and buy dividend-paying stocks simply because the stocks have higher yield. The possibility of such an ill-advised decision does not, however, detract from the fact that there are sensible ways to scale back Treasury exposure and increase allocations to other asset classes with more attractive yield-to-risk characteristics.
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