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Using High-Dividend Stocks as a Bond Substitute

In reply to last wednesday’s article about low bond yields, a few readers wrote in with similar questions. Here’s one:

With bond fund yields so low (less than 2% on Vanguard’s Total Bond as you stated), should investors consider allocating a modest portion of their bond allocation to stable large cap stocks that offer a dividend of 3%+? Seems like this would be a worthwhile risk.

I think it’s easiest to break this question down into two separate pieces:

  1. How differently do large-cap high-dividend stocks perform than the rest of the stock market, and is there something in those differences that makes them particularly useful as a bond substitute?
  2. Might it make sense right now to shift a portion of the portfolio from bonds to stocks?

With regard to the first question, I think the following Morningstar chart is interesting. It shows the performance of Vanguard’s High Dividend Yield Index Fund (in blue) as compared to Vanguard Total Stock Market Index Fund (in orange) and Vanguard Total Bond Market Index Fund (in green) since the inception of the High Dividend Yield Fund in late 2006. (Click the image to see it in full size.)

MorningstarHighDividend

If Vanguard’s High Dividend Yield Index Fund (with its Morningstar classification as large-cap value and its yield of 3.04%) is a good representation of the type of large-cap high-dividend stocks you have in mind, then I think it’s clear that such stocks are still more like other stocks than they are like bonds. That is, the high dividend yield does not make them noticeably less risky.

With regard to the second question — shifting from bonds to stocks in general — I think for most investors such a shift is a dangerous idea.

With bond yields well below historical averages, it’s true that we should expect lower-than-historical-average returns from bonds in the near future.

However, the best predictor I’m aware of for long-term stock returns is the PE10 ratio (a.k.a. Shiller PE), and right now, that ratio is somewhat higher than the long-term average (see here), which suggests lower-than-historical-average returns for (U.S. large-cap) stocks as well.*

In other words, while bond yields are crummy right now, stocks aren’t exactly a red-hot bargain either.

And, more importantly, even if an investor comes to the conclusion that stocks are a decidedly better bargain than bonds, there’s the question of risk tolerance. If the investor’s portfolio was already set so that its risk level was as high as the investor’s tolerance could handle, then bumping up the risk doesn’t make sense. So it is only the unusual investor with excess (i.e., currently-unused) risk capacity for whom shifting further into stocks could make sense.

*While PE10 works better than other stock market predictors, it’s important not to place too much faith in this ratio. According to Vanguard’s research, it has almost no predictive power over short periods. And even over long (10-year) periods, it predicts less than half of stock return variation.

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Comments

  1. That graph is a picture worth 10,000 words, Mike!

  2. Mike,

    I generally agree with you – stocks are a poor substitute for bonds.

    However, you could consider using cash equivalents (CDs, saving deposit, money market accounts) as a potential bond substitute if you are overly concerned about interest rate risk. This, of course, doesn’t help with yield which is part of the original question, but it might make sense for some.

  3. very sound advise in this article…thanks

  4. Agreed, but… it’s only true if you’re defining “risk” as whether you can get the price of your asset back. If you’re looking for income and not worrying about the asset price, then the result is different.

  5. Quick question: On the chart, does the performance of the dividend fund include the dividend payments, or just the price of the fund? Hope that makes sense.

  6. Good question, Julie.

    It includes dividend payments.

    When making Morningstar charts, if you chart a traditional mutual fund, the chart by default shows total returns (i.e., includes reinvested dividends). If you chart an ETF, it shows just price movements.

    If you chart an ETF and a traditional mutual fund together, the chart will show price or total return based on whichever one you entered first (e.g., if you entered the ETF first, it will show just price movements).

  7. I agree that the Shiller P/E is a greater long-term indicator for stock market performance. It can also set the stage for the following year, although as the Vanguard study pointed out, it is not perfect.

    When Shiller P/E is above 20 (as it is now) the average S&P 500 return over the next year has been 2.2%. When below 14, average return over the next year is 17.1%. Between those two market has returned 5.4%. (Source: Ned Davis Research)

    While the Shiller P/E helpful, it is just a snapshot in time. It is critical to understand what is driving the earnings.

    As an example, the Shiller P/E for Greece right now is 2.6. The lowest in the world. Still, one wouldn’t want to rush to invest over there given the depression economics.

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