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Dividend Payers Hold Appeal, but Be Mindful of Risks
MORNINGSTAR - Jan. 24, 2012 - By Christine Benz
Don't swap your whole fixed-income position for dividend-paying stocks.
Question: Are high-dividend-paying stocks a decent proxy for bonds if you think interest rates are going up?
Answer: Possibly, but only in small doses, particularly if stability of your principal is as big a goal for your fixed-inc
ome portfolio as is current income.
It's easy to see the appeal of dividend-paying stocks versus bonds. For one thing, bond yields are downright depressed because of a stampede into fixed-income assets during the past few years: Investors are also rightfully concerned about what a sustained period of raising interest rates could mean for bond prices. (A new supply of higher-yielding bonds will tend to depress the prices of older, lower-yielding bonds.)
Due to that unattractive convergence, I've been hearing from a lot of investors who have become interested in master limited partnerships because of their often-high yields, and I have written about the viability of preferred stock for retiree portfolios. In addition to those more exotic income-producing vehicles, some investors have also gravitated toward plain-vanilla dividend-paying stocks.
It's easy to see the appeal. Some high-quality dividend-paying stocks in the health-care, telecom, and utilities sectors have yields of 2%, 3%, 4%, or even more, making them competitive with bonds on a yield basis alone. Moreover, these stocks generally have greater capital-appreciation potential than do bonds and bond funds. For bond-fund investors, by contrast, yield usually forms the lion's share of any total return you pocket.
Tax treatment is another big point in favor of dividend-paying stocks. Through 2012, investors in tax brackets of 25% or above will pay just 15% on qualified stock dividends, and those in the 10% or 15% tax brackets will pay nothing. Bond income, by contrast, is taxed at the investor's ordinary income tax rate, which can range as high as 35%. (Note that barring Congressional action, that tax treatment will expire in 2013, and investors will once again pay tax on dividends at their ordinary income tax rates.)
Due to all of these positive attributes, dividend-paying stocks could work well as a component of a portfolio that would otherwise be devoted to fixed-income securities. At the same time, however, I'd caution against going overboard with such a shift. The key reason is volatility.
Income Security Recommendation February 2012 Issue.
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