Dividend-paying stocks may look attractive in a low-yield market but they are not a substitute for the safety of bonds, according to Vanguard's chief economist.
There is no easy answer to what to do when money market funds, long-term Treasury bond funds and municipal bond funds are yielding miniscule interests, Vanguard chief economist Joe Davis said in his recent blog. Some would turn to dividend-paying stocks, but they don't guaranteed better returns, he said.
"Dividend-paying stocks are not bonds," Davis cautioned. "Indeed, by their name, they are stocks and thus are going to possess more of the risk-and-return attributes of stocks than bonds. Income-focused stock funds, be they dividend-paying funds or REIT funds, tend to correlate with the broader equity market."
As bonds made their slow but steady climb over the last few years, dividend-paying stocks did better sometimes, but not always, and they sometimes underperformed bonds, he said.
Substituting dividend-paying stocks for bonds makes for a more aggressive and more stock-heavy strategic asset allocation, he said. The strategy can lead to higher nominal returns over long periods of time, but that is because stocks are riskier and more volatile than bonds, he said.
"Vanguard believes it is important for investors to view their portfolios from a total return perspective, rather than simply in terms of potential income," Davis said. "If you hope to gain more income by increasing your allocation to higher-yielding bonds or dividend-paying stocks, you should be aware that your portfolio volatility will likely increase as a result."