Stocks That Keep Paying You Back

Before the market crash last year, investors were woefully underexposed to bonds. A 2008 survey from the Investment Company Institute revealed the scary truth:

Source: ICI.org.

Based on this data, then, it's no surprise that it's been a very rocky year for investors of all ages. To put this in some perspective, despite the nine-month rally we've had, the S&P 500 still remains about 30% off its October 2007 highs. Meanwhile, the aggregate U.S. bond market stayed positive -- and a lot less volatile.

Indeed, over the past 10 years, the S&P has posted negative returns while major bond indexes have delivered steadier -- not to mention positive -- growth.

Don't all jump at once
Data such as this makes it clear that investors needed more fixed income in their portfolios before last year's crash -- and the nauseating stock market volatility, as well as a renewed hunger for income, seems to have been a wake-up call. Despite the recent market rally, the shift in investor funds toward bonds in 2009 has been nothing short of biblical:

Source: ICI.org as of Dec. 9, 2009.

No, that's not a misprint.

But these new bond investors are taking on more risk than they might think.

"Junk" bond funds, which have a higher chance of default and thus have higher yields to compensate for the extra risk, have experienced record inflows of cash this year on the back of record performance. Companies with junk bond ratings include Wynn Resorts (NASDAQ:WYNN) and Hertz Global (NYSE:HTZ).

Sure, junk bonds deserve attention, but because they are issued by less stable companies, they aren't the safe haven investors imagine bonds to be. It's even more important to be cautious today following the record-setting performance and investor inflows. You really don't want to be the last one to the party in this asset class.

Know the rules before you play
Jumping into bonds isn't necessarily a bad thing, of course, but investors do need to keep a few things in mind:

1. Bond prices and yields have an inverse relationship. As interest rates rise, bond prices fall, and with interest rates near record lows, there's really only one way bond prices can go from here. In fact, the president of the Philadelphia Federal Reserve recently said that interest rates will need to rise "very rapidly" once the economy recovers, lest we risk higher inflation.
2. Long-term bonds are more sensitive to changes in interest rates than short-term bonds. If rates do rise rapidly, current long-term bonds (10+ years to maturity) would drop in value more sharply than short-term bonds.
3. Inflation isn't a major concern right now, but it very well could be in a few years -- and that would be bad news for bond investors. Inflation eats away the value of bonds, because you're lending money in today's dollars that will be repaid in tomorrow's dollars. By the time you get your money back, it won't be able to buy as much as today, thanks to the cost of goods and services increasing with inflation.

Consider another sandbox
All that being said, bonds are an essential part of any portfolio. But as with any investment, "price is what you pay, value is what you get."

The potential for higher interest rates and inflation down the road, together with tightening yield spreads, means bonds are less attractive today than they once were.

Instead, now's a great time to double down on dividend-paying stocks. While dividends are never guaranteed, dividend payouts can grow at a rate faster than inflation and have the added bonus of capital appreciation from the stock price.

But why now?
Right now, there are plenty of high-quality dividend-paying stocks, not only sporting yields near or above 10-year Treasuries, but also with plenty of cash to fund and grow their payouts. Here are just a few:

Source: Capital IQ.

While the interest received from Treasuries is guaranteed, whereas dividend payments aren't, each of these stocks has a track record of rewarding shareholders with consistent and growing dividends and appears poised to keep doing so for some time.

While a 10-year Treasury will pay you a fixed 3.5% yield per year on your investment, the same investment in any of these stocks will likely have a larger annual payout by the end of those 10 years. That's why now is an intriguing time to consider strong dividend-paying stocks.

Finding the right mix
If last year's market volatility has made you reassess your risk tolerance and become a more conservative investor, that's great. It's important to remember, however, that bonds -- like any investment -- come with their own set of risks. Like stocks, they can fluctuate in price up to maturity. Balancing high-quality bonds with dividend stocks that keep paying you back is a solid approach to investing in an uncertain market.

Good companies with well-covered dividend payouts are exactly what James Early looks for at our Motley Fool Income Investor service -- and he's finding plenty these days. If you'd like to see what the team is recommending now, consider a 30-day free trial. You'll also see all of the past recommendations and the best bets for new money now. Just click here to get started. There's no obligation to subscribe.

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This article was originally published on Sept. 18, 2009. It has been updated.

Motley Fool Pro analyst Todd Wenning would like to recognize "The Bar-BQ Ranch" in Harrisonburg, Virginia, for its excellent hush puppies. He does not own shares of any company mentioned. Linear Technology is a Motley Fool Stock Advisor selection. VF is a Motley Fool Income Investor recommendation. Novartis AG is a Motley Fool Global Gains pick. The Fool has a disclosure policy.