As investors draw closer to retirement, there's a natural tendency toward risk aversion that leads many to place their savings into bonds. And against the current market backdrop, fixed income seems like an especially appealing alternative for those looking to avoid the volatility and systematic shocks of stocks. I would suggest, however, that investors today--especially those approaching retirement--should beware of tying up savings in fixed-income securities. The elements are in place for a period of substantially rising interest rates, and current bond holders are going to see their portfolios struggle to even keep up with inflation.
How is it I'm so certain that interest rates are soon to sharply increase? For starters, the Fed has been keeping interest rates artificially low. The current return on one-year risk-free bonds is next to zero. Rates have no place to go but up. Additionally, demand for borrowed capital is surely bound to rise as businesses start funding for growth and cash-starved municipalities turn to bonds to fill funding gaps. This increased demand will doubtlessly be met with higher interest rates. And as rates rise, current bond holders will find themselves locked in to painfully low rates.
As for those "risk free" investments, T-bills are currently priced to yield less than 0.5%. It's hardly likely they'll even come close to keeping pace with inflation, which over the last decade has averaged around 2.7%.
Meanwhile, retail investors have been throwing money at bonds and bond funds like never before in history. And if there's one thing I've learned in my 43 years in the investment business it's that people always act in this kind of an extraordinarily extreme manner at the end of a major trend. The behavior of the masses, in other words, tells me we're at the end of a big cycle for fixed income. And that means risk is high and opportunity is limited for bonds.
It also means that somewhere else along the investment continuum, somewhere where current popularity barely exists at this hour, risk is close to minimal and opportunity is closer to maximum.
Dividend-Paying Stocks: An Interesting Alternative
Investors, then, are truly caught between a rock and a hard place--forced to weigh the unsatisfying returns of bonds against the uncertainty of stocks. Fortunately, there is a solution to the retirement-aged investor's dilemma: high-dividend-paying blue-chip stocks. After all my years in investing, I have found dividend-paying stocks to be the last remaining asset class to represent great value. Dividends not only provide income for the retirement-aged investor who needs it, they also present meaningful growth potential for those long-term investors who seek it.
With interest rates as low as they are, the dividend yield on many companies' common stocks are on par with the interest paid on their fixed income securities. In other words, dividend-stocks these days are providing the same steady income stream that retiring investors look for in bonds. And they are highly liquid. Bond trading can at times involve high transaction costs, and investors occasionally face problems with liquidity. Retirement-aged investors relying on their savings should value the increased liquidity of stocks over bonds as a safety net for unexpected expenses.
Also demanding of investor consideration are the tax benefits of dividend payments vis-à-vis taxable coupon payments. Dividends that meet the criteria to be considered "qualified" are taxed at the capital gains rate. When compared with coupon payments that are treated as taxable income, the tax savings of dividend-paying-stocks over bonds can be substantial.
Most importantly, however, dividends have the potential to grow. While a coupon rate remains fixed throughout the life of a bond, the dividend on a stock can increase at the company's discretion. My company recently completed a detailed study of The Proctor & Gamble Company for an upcoming report called "Dividend-Paying Stocks: The Solution to the Retirement-Aged Investor's Dilemma". According to our analysis, Proctor & Gamble has increased its dividend by an average of 9% per year over the past 52 years. Said another way, P&G's 2009 dividend is 88 times larger than the dividend it paid 52 years ago. Dividend-paying-stocks also allow investors to accrue capital gains on their principal, in contrast to bonds which offer no potential for principal growth.
More Than Income
Dividend stocks should catch the eyes of investors looking for long-term growth as well. By reinvesting dividends into more shares of stock, substantial growth is possible. To illustrate, imagine having purchased a single share of Coca Cola stock in 1919 for $40 and holding it until 1999. The value of the capital gain of that share combined with the value of its dividend payments would have reached an impressive $298,218. If you had reinvested those dividends into more Coke stock, however, the value of your accumulated shares would have reached a staggering $5,866,413. Good luck finding a bond with that return!