Why Dividends Are Safer Than Fixed-Income Investments

by Marc Licthenfeld, Investment U Senior Analyst
Wednesday, November 23, 2011: Issue #1649

You know you’re a market junkie when, after a long week of writing about the markets and watching practically every one of your stocks’ ticks, the first thing you do Saturday morning is devour the business newspapers.

That’s me. And since I’m the Editor of The Ultimate Income Letter, I was like a kid on Christmas morning this weekend when Barron’s cover story was about how investors can find yield in this low interest rate environment.

I’ve been reading Barron’s for 20 years and think they do a nice job.

But the advice in this week’s cover story was so off the mark my mouth was agape like a voter who just heard that those in Congress are allowed to trade on very sensitive non-public information.

The Barron’s article detailed 11 types of investments that can help generate above-average yields, including several fixed income ideas. While I believe bonds warrant a place in a well-rounded portfolio, I would be very hesitant to add any new bond positions unless they’re shorter term in nature.

Interest Rates Are Low

Interest rates are at historic lows. To get two percent on a Treasury, you need to lock up your money for 10 years. Buy a five-year Treasury and you’ll take home a whopping 0.91 percent.

Perhaps interest rates stay at these low levels for a while. It’s hard to imagine they can go much lower. The chances are better that three and certainly five years from now, rates will be higher. As a result, bond prices will fall.

Here’s why. If you buy a two-percent 10-year bond today at par, 100, what would happen to demand if, next year, new 10-year Treasuries carry interest rates of 2.5 percent? In order to be able to sell your two-percent bond, you’d need to lower the price. No one is going to pay full price for a two-percent bond when they can get 2.5 percent in the open market.

Some of the ideas in the Barron’s article might make sense if you’ve owned them for a few years already and are enjoying the above average income they spin off. But to buy them now is like buying a house where you know there’s a sinkhole in the front yard.

Other Examples

Let’s take a look at what’s wrong with some of the recommendations in the article.

Closed-End Bond Funds – It’s a tough time to buy bonds right now, but it’s a horrible time to buy bond funds. At least when you buy a bond, you’ve got a good shot at getting your money back at maturity. But with a bond fund, there is no maturity and when rates go up, the value of the bonds held in the fund go down.

Even if you’re in a fund trading at a discount, the likelihood of making money in a rising interest rate environment is fairly slim.

High Yield Bonds – If interest rates rise, high yield bonds will get crushed, particularly those that mature in a longer timeframe.

In both of the above cases, if you’re going to buy corporate bonds, you’re better off buying those with very short maturities. Oxford Club bond maven Steve McDonald writes about this very topic in the upcoming issue of The Ultimate Income Letter.

Municipal Bonds – The fears about muni defaults are overblown. According to the Nelson A. Rockefeller Institute of Government at the University at Albany, state tax revenue was up 8.6 percent in the fiscal year for 46 states and the most recent quarter was the sixth straight quarter of growth.

Also, Standard & Poor’s recently reported that “muni” bond defaults were down 69 percent in 2011.

Personally, I like municipal bonds as their after-tax returns beat Treasuries. However, I would take the same approach to them as I would to other bonds – stay away from funds and buy individual bonds. And only buy those with shorter maturities – one to three years.

I suspect rates will stay stable or even fall in the next 12 to 24 months, but should eventually rise over the long term. You don’t want to get caught holding any bonds that mature in 10 to 30 years if rates start climbing in the future.

Equipment Leasing – Firms buy groups of contracts signed by companies that are leasing heavy equipment such as drilling rigs or railroad cars. It’s similar to buying a mortgage-backed security in that the assets are pooled, bundled and then sold to investors.

Yields are decent in the six-percent to eight-percent range currently.

However, this is a terrible idea for most investors. The investment is a bit esoteric for most people and really requires a significant amount of work to understand just what you’re getting into and checking out the broker selling it. It’s not like you can call up Schwab and buy an equipment-leasing direct investment. Specialized investment firms offer them and should be scrutinized thoroughly.

Immediate Fixed Annuities – The only idea I hated more than the equipment leasing suggestion was that of immediate fixed annuities. With a fixed annuity, you send a chunk of money to an insurance company and then you receive a fixed payment from then on for the rest of your life.

If you live long enough, you’ll make more than you contributed. Barron’s quoted Steve Horan, Head of Private Wealth at the CFA Institute, who said, “Some investors are going to die early and since the insurance company isn’t going to have to make their payments, they use them to benefit those still living.”

Isn’t that similar to a Ponzi scheme? I don’t like my payments relying on someone else’s misfortune. I’d hate to be reading a newspaper story about a senior citizen getting hit by a bus and thinking, “That’s terrible, but I hope he was in my insurance company’s fixed annuity pool.”

Rather than sending your money to an insurance company, who will then pay generous commissions to the broker who sold you the annuity, invest the money yourself and take out what you need each year.

To get decent yield today, have a combination of quality dividend paying stocks and some bonds in your portfolio – though if you’re adding bonds, be sure they’re shorter-term maturities.

For long-term investors, I prefer dividend paying stocks that increase their dividend on an annual basis. By choosing the right stocks, you should be able to stay ahead of inflation with increasing income every year as well as participate in capital appreciation when the stock price goes up over the course of time.

Good investing,

Marc Lichtenfeld