Dividend Paying Stocks in Lieu of Bonds?
Think Again
by Christopher Beringer

     There is a lot of noise about dividend paying stocks as a replacement for bonds.  The theory goes that bond yields are low and there is a possibility of interest rates going up, which will cause bond prices to decline.  Meanwhile, dividend yields are high, dividend tax rates are low and will continue to be low, which means that dividend paying stocks are a better investment than bonds.

     We are not debating which is a better investment, but pointing out that dividend paying stocks should not be used as a replacement for bonds.  

     Let's go back and review how dividend paying stocks might perform in three economic environments:

1)  Slow Growth:  Stocks will be muted, but dividend rates should stay steady.  Prices will increase, dividend rates will stay strong (on a relative basis) and dividend paying stocks should perform well.

2)  High Growth:  Stocks will advance quickly (causing dividend rates to decline) and the combination of a strong beginning dividend and company expansion will mean dividend paying stocks will perform strong, but not as well as high beta names.

3)  Double Dip:  Companies will be forced to cut their dividends and a sell off of those names is a possibility.  

     Essentially, dividend paying stocks work well in two out of three economic environments.  Because the possibility of the third economic environment exists, bonds should remain a basic component of a diversified portfolio.

     Advocates of replacing bonds with dividend paying stocks do not seem to have appreciation for how a bond is constructed. Simply put, a bond holder loans money for a period of time, receives interest payments and at the end of the term receives the return of principal (assuming the borrowing entity does not suffer a default).  Bonds provide steady income and at the end of an investment period, receive full principal repayment.   During the holding period, various factors affect the price (supply and demand, interest rates, credit ratings, etc.), but the patient investor should receive principal at maturity.  There is never an implicit guarantee that a stock will return its initial cost basis.  This is a major difference between an equity and debt security and this difference is a key component of what makes bonds so valuable.

     At The Beringer Group, our economic forecast is leaning towards a slow growth environment.  This means that we believe dividend paying stocks will be a good investment.  We also believe the possibility of a double dip recession exists and it would be irresponsible to tell our clients to replace their bonds with dividend paying stocks.

     If you have any questions about the above please contact Chris Beringer at The Beringer Group, 610.293.2020 for a free consultation.