The following is a guest post by Ben Carlson from A Wealth of Common Sense
“Compare this with a 50% drawdown in stocks in the past bear market and you can see that bonds and stocks do not have the same characteristics for loss. Interest rates would really need to spike higher in a very short period of time to equal stock losses. And unfortunately, rates can stay low for long periods of time.”
With interest rates at generational lows, investors are in search of yield. The 10 Year U.S. Treasury is currently yielding around 1.7%. As late as 2006 the 10 Year yielded over 5.0% and in 2000 it was over 6.0%. By keeping short-term interest rates pegged at basically zero, the Fed is forcing investors to reach for yield and move out further on the risk spectrum.
Stocks have been a huge beneficiary of this interest rate policy. Since the lows in 2009, stock markets around the globe are up over 100% in many cases. Bonds have also performed well and now have lower interest rates to show for it. Because of the low rates many market experts are now saying the bond market is in a bubble that is bound to burst through rising interest rates (rates and prices are inversely related).
This interest rate environment has allowed corporations to issue debt at very low rates. Easy access to debt and a recovering economy has given corporations the luxury of being able to buy back their own shares and increase dividends after many had suspended or cut back on this shareholder friendly activity at the depths of the Great Recession. This has led many investors to look at stable, blue-chip dividend-producing stocks as alternative sources of yield in this low interest rate environment.
Over time dividends are a great way to increase your income and possibly even reduce the volatility of your stock portfolio. But it would be a mistake to assume that dividends can act as a substitute for the bond portion of your portfolio. This is because the volatility and risk of large losses is still much greater with dividend producing stocks than with bonds.
Looking at Dividend ETFs
Let’s take a look at the historical performance of some dividend ETFs to see why you should not look at them as bond-like investments. WisdomTree has become known as a proponent of dividends based on their founder, Jeremy Siegel, and his research on dividend investments. The WisdomTree Total Dividend ETF (ticker DTD) tracks the company’s dividend index. They also have the WisdomTree Dividends ex-Financials (ticker DTN) that is similar but doesn’t carry financial stocks which had artificially high dividend rates in the crash that were suspended in most cases. And Vanguard has the Dividend Appreciation ETF (ticker VIG) which tracks an index of stocks that have a history of increasing dividends consistently over time.
In the chart and graph below are some relevant statistics on these funds since their inception (all started in 2006) and also a graph that shows how a $10,000 investment in each of these ETFs has performed against the S&P 500 Index in that period of time.
You will notice that dividends helped all of these funds outperform the S&P 500 over this time frame. That makes sense since reinvested dividends play a larger role in your long-term performance than most investors assume. But if you look at the standard deviation and beta (correlated volatility to the S&P) numbers you will notice that the results look very similar to most stock funds.
The VIG has a lower beta and standard deviation of returns but the DTD and DTN aren’t much different and in fact have a higher standard deviation than the market. This means they were actually more volatile than the market since 2006. And the graph shows that dividends didn’t help too much with the drawdown in 2008 and 2009 either. The WisdomTree ETFs both lost over 50% of their value and the Vanguard ETF was down more than 40% from peak to trough.
Looking at Bond ETFs
Now let’s look at how much bonds can lose if interest rates rise in the future. The IEF ETF tracks the 7-10 year Treasury Bond Index and currently has a duration or 7.56. That means that for every 1.0% increase in interest rates the fund would be expected to lose a little over 7.5%. Netting out the current 1.6% yield would give you a total loss of just under 6.0%. Compare this with a 50% drawdown in stocks in the past bear market and you can see that bonds and stocks do not have the same characteristics for loss. Interest rates would really need to spike higher in a very short period of time to equal stock losses. And unfortunately, rates can stay low for long periods of time.
Longer-dated bonds will have a higher duration so you could see larger losses in those securities when rates rise. On the other hand shorter duration bonds will lose less once rates rise. So if dividends aren’t the answer to calm your bond nerves then what are the alternatives?
Reaching for yield usually does not end well for investors. That is one of the defining lessons of the subprime mortgage debacle. Higher reward always leads to higher risk. To increase your returns over treasury rates, money markets and CDs you could look to corporate bonds and emerging markets. The LQD ETF tracks the corporate bond market and currently yields about 3.6%. And EMB is an emerging markets bond ETF that yields 4.1%.
These still are not the 5-6% rates of the past but they still offer a nice spread over low-yielding treasuries market and near-zero money market funds. And they have similar duration numbers to the IEF so your interest rate risk is similar in these funds if rates rise. Fixed income is not where you should plan on taking on huge amounts of risk anyways since that is the portion of your portfolio that is used to reduce volatility and preserve your savings.
To recap, it makes sense that dividend stocks can be used to increase your long-term investment performance but they should not be considered an alternative to bonds. It is also possible to decrease your volatility and increase the quality of your portfolio through dividend-paying stocks. Make sure you understand the volatility and loss attributes before assuming that dividend stocks will be the answer to your bond worries. You need to make sure you make and apples-to-apples comparison so you know all of the risks involved.
This was a guest post by Ben Carlson from A Wealth of Common Sense. Ben writes about personal finance, investments, investor psychology and using common sense to get ahead financially. You can also follow him on Twitter.