Vanguard Expert: Dividend-Paying Stocks ‘Are Not Bonds’

Top economist at Vanguard cautions investors against substituting high-yield stocks for bonds

More than $18 billion has gone into the equity-income funds and ETFs in the first eight months of this year, according to Lipper–the largest amount of cash flow of any Lipper equity fund category year to date.

But investors need to watch their backs, cautions Vanguard Chief Economist Joe Davis in a recent blog post: Substituting dividend-paying stocks for bonds entails taking on greater risk.  

“I’d like to point out that dividend-paying stocks are not bonds,” Davis explains in the blog. “As one can see … income-focused stock funds, be they dividend-paying funds or REIT funds, tend to correlate with the broader equity market.”

Joe Davis. Vanguard's chief economistWhile at times dividend-paying funds can outperform the broader equity market, using dividend-paying stocks instead of bonds in order to generate greater income means that investors are employing “a more aggressive and more stock-heavy strategic asset allocation,” Davis (left) points out.

“In doing so, we would expect an increased likelihood of higher nominal returns over long periods of time, yes, but that’s not necessarily because of the higher anticipated income stream. Rather, it’s because stocks are riskier and more volatile than bonds,” the economist states.

Vanguard points out that its Total Bond Market Index Fund (VBMFX) is currently yielding 2.4%, as of Nov. 3, and the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) has a yield of 2.55% through Nov. 3. Since 1997, bonds have had annualized returns of 6.1% on average vs. 4.2% for stocks, 5.7% for dividend-paying stocks and 8.2% for REITs.

Holding assets in a conservative bond fund may provide below-average total returns in the next decade, Davis says, but “the volatility-dampening properties of bonds should be carefully taken into consideration when developing a sound investment strategy.”

“I just hope that we all appreciate that dividend-paying stocks are not substitutes for Treasury bonds,” he concludes. “That’s not to say that dividend stocks will not outperform a broad bond portfolio over the next several years. Rather, it’s simply to say that such an income-focused strategy is not a no-brainer, nor is it risk-free.”

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