As absolute yields on bonds continue to trend at 60-year lows, investors have shown a great deal of apathy for the asset class. Not helping matters is the fact that for one of the few times in recent history, the dividend yield on the S&P 500 exceeds that of the 10-year Treasury bond. Thus, many of the talking heads on financial television programs have come to the conclusion it is easy money to substitute dividend-paying stocks for bonds in a portfolio-because some dividend yields on stocks are higher than the yield-to-maturities available on bonds. As they describe it, such a trade is a win-win, for as stock prices rebound, those dividend-paying stocks will participate and appreciate, while bond prices will decline as yields go up.
Sounds like good advice. Or is it?
For one thing, it brings to mind other "no-brainer" trades like hefty allocations to subprime mortgage-backed securities (Hey! They were all "AAA"-rated!), or substituting traditional fixed-income allocations with absolute-return hedge funds. (How did that feel in 2008?)
The dividend stock clamor is perhaps not in the same league of bad advice, but it is still appropriate to exercise a little caution here, especially if you believe in the principles of modern portfolio theory and the importance of diversification.
After all, abandoning an asset class like fixed income can be a costly proposition. Stock prices may or may not be staging a rebound, and bond yields may or may not be on the precipice of a big increase. With Europe still in chaos, emerging markets grappling for a soft landing and the U.S. political scene fraught with uncertainty, there are more questions than answers about global growth prospects in 2012 and beyond. In fact, most economists' base case is for a mediocre growth environment vulnerable to shocks. Indeed, while stock prices may be a forward-looking barometer, the future is so cloudy that it is difficult to trade beyond the news flow. There is higher-than-average volatility, and investors are only giving weak consideration to fundamentals.
Furthermore, observers have been predicting that bond yields will rise for the last three years, but bonds continue to confound and contradict those expectations. That might continue, especially with the Federal Reserve Open Market Committee making an outright commitment to keeping interest rates at "exceptionally low levels" until mid-2013 and maybe even beyond.
Even so, rising bond yields should not be a death knell for fixed income. While it is true that rising interest rates would erode the prices of investors' bonds, it is important to remember that when interest rates rise, income increases as long as a portfolio is actively and professionally managed to maintain its duration, or interest-rate sensitivity, over time. In this way, portfolio managers bring new, higher-interest-paying bonds into their portfolios, and thus more income. And income historically represents more than 70% of a bond portfolio's total return over the course of its lifetime. This gives the fixed-income asset class an important long-term advantage.
While rising interest rates will hurt total returns for the asset class in the short term, it is important to keep in mind that interest rates do not move in a straight line and do not go up indefinitely. Indeed, the yield curve can invert, steepen, flatten or shift in a parallel fashion. An active, professional bond manager will attempt to anticipate these changes and position portfolio maturities accordingly to protect against dips in price. Also, interest rates-like the economy-move in cycles, rising and falling over time. In a rising-rate environment, an investor who liquidates his portfolio misses the potential for recovery, which means that selling in a panic may be a poor idea.
For sure, many segments of the bond market are expensive right now, especially Treasurys. However, they are not the only game in town when it comes to fixed income. There are many other opportunities for enhanced yield in areas like corporate and municipal bonds, and even in structured credit. While absolute Treasury yields are very low, the risk premium or yield spread on some of these other fixed-income investments are still wide by historical standards, offering good compensation for the incremental risk. Though some segments of the stock market offer cheap valuations by historical standards, dividend-paying stocks are now generally trading at a premium as a growing flood of investor interest has brought in new money and spurred them to outperform.