Think Dividend Stocks, Not Bonds

As the lead analyst of Motley Fool Income Investor, it's no secret that I favor dividend-paying stocks. However, what I don't favor these days are bonds, especially those of the long-term Treasury variety.

So, today I'll tell you what to avoid in the bond universe. What's more, I'll come back next week to tell you why dividend-paying stocks represent a far better choice for most income investors in today's market.

Of course, as I mentioned a few weeks ago, not all dividend-paying stocks are created equal. So I'll follow up with an article that explains how you can start finding quality dividend payers for your own portfolio. Fair enough? Swell. Let's get started.

Avoiding bondage
As a big fan of proper diversification, I hate to sit back and shoot holes into an entire asset class. Still, that's exactly what I'm going to do here. Though I'm not advising anyone to chuck a prudent, long-term diversification strategy into the porcelain goddess, the fact is that most bonds simply aren't that compelling for investors who have money to put to work right now. There are better alternatives out there.

Again, I'm not saying it's time to drop every bond in your portfolio; many of them may have been very good investments when you purchased them. This, however, is not the time to back the truck up on bonds -- unless, of course, you plan to simply run them over and drive away laughing like a maniac.

Despite more than a year's worth of short-term interest-rate increases by the Federal Reserve, bond yields remain quite unfavorable on a comparative basis, and run a fairly large risk of being outpaced by inflation in the current environment. Throw in taxes, if you're investing in a non-retirement account, and you've got a seriously underperforming investment on your hands.

Further, despite five interest-rate increases in as many quarters, the Fed is actually bumping rates higher at a very modest pace. Keeping short-term rates low like this will inevitably put a lid on long-term rates as well. When you toss in the fact that the Fed's message has largely been that inflation is under control, you've got a situation where intermediate- to long-term yields are in the stinkpot.

Consider this: Despite the fact that the federal funds rate has more than doubled from 1% to 2.25% over the past year, the yield on both the five- and 10-year Treasury bond remains virtually flat from the year-ago period. So, while short-term rates have been rising, intermediate- and long-term rates have stayed the same.

This phenomenon is referred to as a flattening of the yield curve, which generally creates an environment where longer-term bonds are less attractive than they otherwise might be.

Put another way, the current rate on the five-year Treasury bond is about 3.7%, and the 10-year is running at just 4.25%. That may not sound too bad in this low-yield world of ours, but the fixed nature of bond investing means you must place more emphasis on inflation. The Consumer Price Index (CPI), which I believe modestly understates the true rate of inflation, pegs this cash-eroding figure at about 3.3% right now, and the collective outlook is for a jump to 3.5% over the course of the year. This means that, after accounting for inflation, you'll nearly be penciling in a big ol' goose egg on the five-year Treasury and a lovely 0.75% on the 10-year -- before taxes. Ick.

Typically, longer-term Treasury bonds have yielded between 2% and 3% more than the rate of inflation. As you can see, that premium is less than 1% today. Considering that I've managed to lock in an average yield of 4.55% for Income Investor subscribers via a blend of dividend-paying stocks -- not to mention the market-doubling capital gains we've achieved -- you can see why I'm less than enthused with these bond returns. Safety is great, but I'm simply not willing to take a 0% effective return to get it.

Short still comes up short
Though short-term bond yields have doubled right along with the federal funds rate, they also remain less than compelling. The yield on the one-year Treasury is currently about 2.85%. Again, that may not sound too bad to yield-starved investors, but why go there when you can get a 2.35% savings account at several online banks -- like ING Direct -- with no fees, no minimum investment, and no tying up your funds?

Suffice it to say that, despite their professed safety, you could be leaving money on the table if you invest in Treasuries with a short-term time frame in mind. Perhaps even worse, if you invest in longer-term Treasuries, you could bleed a small amount of money for a long period of time. Neither option is terribly desirable from my point of view.

So what should you do with that cash that's burning a hole in your pocket as you read this? As I mentioned, dividend-paying stocks remain the best investment option for investors seeking inflation-protected income and principal growth. With yields on many quality companies such as Diageo (NYSE: DEO  ) , Heinz (NYSE: HNZ  ) , and U.S. Bancorp (NYSE: USB  ) rivaling those of five- and 10-year Treasuries, these investments deserve some attention -- and I'll be back next week to give them some.

If you simply can't resist the urge and you absolutely must add some bonds to your portfolio, I believe Treasury Inflation-Protected Securities (TIPS) are still the safest bond investment available in this environment. Exchange-traded funds (ETFs) such as the iShares Lehman TIPS (NYSE: TIP  ) are an easy way to dabble here.

With all this bond negativity, some of you may be thinking of shorting the category altogether via securities such as the Lehman 20+ Year Treasury Bond (AMEX: TLT  ) , but I wouldn't recommend that route. First, yields can be very volatile in this environment. Second, an overall decline could take some time to play out if interest-rate increases by the Fed remain measured. And lastly, when you short a security, you must pay the dividend on that security whenever it comes due. Over time, that will significantly reduce any profit you might enjoy with such a strategy.

See you next week. Until then, Fool on!

Mathew Emmert was nearly trampled to death by the crowd last week while attending the presidential inauguration, but it was worth it to see democracy in action. He's the chief analyst ofMotley Fool Income Investor, and he doesn't own shares in any companies mentioned in this article. The Fool has a disclosure policy.


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