Thursday, April 29, 2010

Fixed Income for dividend investors

Over the past century stocks outperformed bonds rather handsomely. One dollar invested in the S&P 500 in 1802 with reinvested dividends would have turned into $12.70 million by 2006; a similar investment in fixed income would have only grown to $18,235. Most investors have far shorter investing periods than two centuries however.

Source: Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies

While US stocks have always produced positive total returns over any 30 year periods, this has come with tremendous volatility in total returns. Bonds on the other hand could also experience volatility in total returns, since they are particularly sensitive to changes in interest rates. The one thing which is helpful is that the coupons are fixed, which at least provides some stability of nominal income.

As mentioned earlier, bonds are sensitive to changes in interest rates. Bonds have been in a bull market for almost three decades now, fueled by a decrease in yields in the 30 year Treasrury Bond from 15% in the 1980's to 4.50% now. Most investments in bonds can hardly keep up with inflation. Only the TIPS ( Treasury Inflation Protection Securities) offer some inflation protection, as their principal and interest payments adjust to annual changes in the Consumer Price Index. Other than TIPS, fixed income securities typically do not do very well during inflation.

Furthermore most Corporate Bonds also have added risk, since there is always the possibility of default. Many prominent companies which were once regarded as solid blue chips have fallen on hard times and have had to go bankrupt, wiping out both shareholders and leading to huge losses of principal by bondholders. Municipalities, which lure investors with their tax exempt securities, are also prone to defaults. As a result I tend to concentrate my fixed income efforts only to US Treasury Bonds or FDIC insured Certificates of Deposit.

In a previous article I mentioned that a dividend portfolio in retirement must have at least a 25% allocation to fixed income. Despite the fact that I believe dividend growth stocks are a much better investment than fixed income, I still believe that bonds could offer some comfort for diversification purposes. While a bond portion of a portfolio would certainly lose purchasing power due to inflation, it would provide a portfolio with a cushion during market turmoil and during deflationary periods. If we were to experience higher inflation in the future, the dividend stock allocation should do its magic by lifting incomes and stock prices. If we have a repeat of the Great Depression or the Lost two decades for Japan, investors with a bond allocation should sleep better at night.

The way to actually invest in Treasuries is either by directly buying bonds or by investing through a bond fund or ETF. One way to purchase bonds is either directly by participating in Treasury Auctions or by buying bonds through your broker. While some brokers charge a small fee for bond transactions, others do not charge anything. If you decide to purchase your fixed income directly and hold to maturity, then you might consider laddering your bonds. Bond laddering means purchasing bonds with varying maturities, so that one is not overly exposed to interest rate fluctuations. Bond ladders could also be set up in a way that you can have bonds maturing at predetermined intervals of time. This allows investors to allocate bond proceeds to new bonds with the same maturities but different interest rates as the bonds which matured.

The advantage of holding onto individual bond issues is that investors could decide whether to hold to maturity or sell before that. Even if interest rates went to 10% and bonds with 4% yields were trading at steep discounts to par, investors holding to maturity will get their principal back. In addition to that investors would keep receiving the coupon payments every six months. Proceeds could also be reinvested back at the higher interest rates.

Investing in bonds should be done only as a long term investment. There has been a lot of speculation about interest rates rising since at least late 2008, claiming that bond investors would surely lose money over the long term. If one had $1000 in cash and invested in a ten year Treasury bond, they would lock in a 3.80% yield for 10 years. If one were to wait for three or four years however until rates on ten year bonds rose to 6%, then they would receive much lower returns.

The other method to buy bonds is by purchasing a bond mutual fund or a bond ETF. Some of the most active bond ETFs include:

iShares Barclays 20+ Year Treasury Bond (TLT )
Vanguard Long-Term Bond ETF (BLV)
iShares Barclays 7-10 Year Treasury (IEF )
iShares Barclays 1-3 Year Treasury Bond (SHY)
iShares Barclays TIPS Bond (TIP)

The issue with bond funds is that investors are charged annual management fees for them, which lower returns. Some bond mutual funds also tend to sell bonds, which triggers capital gains liabilities.

At the end of the day, dividend growth investing is a superior investing strategy. Adding another low correlated asset class such as fixed income however can smooth volatility in income in times of recessions and deflations. The goal is reducing risk as much as possible and providing a floor to the amount of sustainable income in retirement. Investors need to eat even during recessions. Thus, an allocation to fixed income should provide investors with a peace of mind and reduce long-term risk, without sacrificing long term growth for the rest of the portfolio.

Full Disclosure: Long US Government Bonds

Relevant Articles:

- Dividend Reinvestment is important
- Dividends Stocks versus Fixed Income
- The case for dividend investing in retirement
- Living off dividends in retirement

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