The Safer Alternative to Bonds

Many investors flee to the safety of bonds when times get tough. But right now that's looking like a big mistake. Solid dividend stocks -- including blue chips -- are yielding well above 10-year U.S. Treasuries, and strangely, some of these dividend stalwarts pay higher yields than their bonds offer.

But that's only one of the reasons investors should be frightened of bonds now and instead put their investment dollars in a range of dividend stocks. Below I highlight three areas where you can stuff your cash and offer you a special free report that provides even more dividend ideas.

The trouble with bonds
Bonds are traditionally seen as safe, and not without some reason. They tend to be less volatile than stocks, offer regular interest payments, and have first priority in any liquidation. But with interest rates so low, bond investors are seeing a dicey proposition in the supposedly safe asset class. Take a look at three trends in bond-land.

1. Low interest rates
Investors who demand fixed income regardless of rates have been accepting almost any yield, even those below the level of inflation. Strong corporate borrowers such as Johnson & Johnson (NYSE: JNJ  ) have managed to score interest rates as low as 0.7%, and Google climbed aboard that gravy train as well, despite its own cash hoard.

But with such low rates investors are not only losing purchasing power, their bonds will decline in value if and when interest rates rise again.  

2. 100-year bonds
One solution to the low rates seems to be high-yielding 100-year bonds. But while investors might be able to earn higher interest rates from 100-year notes, it comes at a steep cost. How many centenarian companies can you name? Only a few of the highest-quality businesses will survive the next century. So while you might get higher rates now, there's added principal and business risk.

3. Weak bond covenants
With such low rates, investors have been willing to accept weaker lending terms, or covenants, in order to eke out marginally higher rates. Among other things, covenants constrain what actions the businesses can take and how much leverage they can take on, thus protecting bond investors' investment. If the economic situation gets dire, bond investors may not have the protections they think they have.

It's your move
With dubious opportunities for conservative bond investors, dividend stocks look like a very interesting alternative. As a stock investor you can take advantage of your companies borrowing at historically low rates and generating solid returns for you, plus you get a better income stream -- and one that grows over time, helping to overcome the ravages of inflation. Even the safest corporate bonds can't promise that.

Below I highlight three areas where you should consider parking some cash.

1. High-quality utilities
Perhaps the most obvious place to turn as a bond alternative is high-quality utilities. With a significant portion of their business derived from regulated operations, they can offer a steady return in almost any economic climate. Plus their high dividends help steady their share prices, meaning less volatility. And low volatility is one of the key principles behind my so-called world's best dividend portfolio, which has been trouncing the market lately.

Three of my favorite utilities are National Grid (NYSE: NGG  ) , Southern Co. (NYSE: SO  ) , and Exelon (NYSE: EXC  ) .

Company

Yield

Net income payout ratio

National Grid 5.8% 40%
Southern Co. 4.6% 78%
Exelon 4.9% 52%

Source: Capital IQ, a division of Standard & Poor's.

Each company has a high dividend and a sustainable payout ratio. In January, I detailed why I liked National Grid, a stock that has gone on to perform nicely amid a rocky economic climate. In short, the U.K. utility offers indispensable hard assets, regulated operations, and some international diversity.

Exelon provides low-cost energy from its stable of nuclear plants, giving it a pricing advantage over fossil-fuel peers, though the company has fossil operations, too. Future environmental legislation limiting carbon emissions could help give the company an even bigger relative advantage since nuclear facilities generate minimal carbon.

Southern is interesting because of its good regulatory relationships, which allow it to raise rates, and the growing population in its service area (the U.S. South). While the stock is more expensive than the previous peers on a P/E basis, it's still a solid long-term addition to an income portfolio.

2. High-quality blue chips
You may not like to buy Johnson & Johnson's debt at a meager 0.7% rate, but the company is clearly taking advantage of the low-cost financing, and you can, too, by owning shares of the medical blue chip. The stock offers a 3.5% yield and trades at almost 16 times earnings. Over the last five years the company has managed to grow its payout by nearly 10% a year.

Intel (Nasdaq: INTC  ) should be another interesting play for income investors. With its 4.2% yield and dominant position in chips, investors shouldn't have to worry about this stock providing dividends for decades. It's grown its payout at a 13.5% clip over the last half-decade -- doubling its dividend in the process. The company has bought nearly $7.7 billion in stock over the last four quarters and trades at a cheap P/E of just 9.

3. Mortgage REITs
While the first two options above provide set-it-and-forget-it income investing, this option -- mortgage real estate investment trusts -- can juice yields for the short term. I especially like Annaly Capital (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) , whose business models thrive on low rates. They both pay double-digit yields and could be a good addition to a diversified portfolio. Their yields won't stay high forever, though, so you'll have to be vigilant about rising rates.

Foolish bottom line
While many investors assume that bonds are simply safer than stocks in all market conditions, a portfolio of high-quality dividend stocks can provide better yields and long-term appreciation. If you're interested in more high-yield dividend stocks, then download a free report from Motley Fool expert analysts called "13 High-Yielding Stocks to Buy Today." Hundreds of thousands have requested access to this report, and today, I invite you to download it at no cost to you. To get instant access to the names of these high yielders, simply click here -- it's free.

Jim Royal, Ph.D., owns shares of Annaly, J&J, National Grid, Southern, and Exelon. The Motley Fool owns shares of Chimera, Johnson & Johnson, Google, and Annaly. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, Exelon, Johnson & Johnson, Southern, Google, and National Grid. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. Motley Fool newsletter services have recommended creating a diagonal call position in Intel. Motley Fool newsletter services have recommended creating a write covered strangle position in Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (50)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 08, 2011, at 5:31 PM, jeffpe8 wrote:

    What are the tax implications of NGG? Do you have to file in different states? Is it a problem to hold this in a tax-deferred account?

  • Report this Comment On September 08, 2011, at 5:56 PM, TMFRoyal wrote:

    Hi, Jeffpe8,

    NGG should be just like any other dividend stock (it's not a partnership or REIT). In fact, investors in NGG and other UK-based companies get to take advantage of a tax treaty with the US: no withholding on dividends from UK stocks.

    Foolish Best,

    Jim

  • Report this Comment On September 08, 2011, at 6:08 PM, Pawn49 wrote:

    I have an arguement with some people all the time as to whether Altria at on over 6% yield is a better investment than bonds. Is Verizon really safer than Treasuries? I would rather have a rising dividend than a return that stays the same for the next few years. Bonds are more of a gamble than some high yielding stock right now, in my Foolish opinion.

    Fred

  • Report this Comment On September 08, 2011, at 6:11 PM, tacrowabq wrote:

    jeffpe8:

    As the name suggests, a tax-deferred account does not pay taxes. That's the best place to hold high-dividend-yielding stocks in my opinion.

    It looks like NGG just pays an ordinary dividend twice a year. If you own it in an IRA, you might be 1099'ed on it, but you would not owe any taxes.

    Since it does not appear to be a limited or master limited partnership, if you owned it in a taxable account, it would just be included as dividend income on your taxes and taxed accordingly.

  • Report this Comment On September 08, 2011, at 7:45 PM, 738TX wrote:

    Re NGG: Why should I pay $50 to buy $52 debt? did I misplaces a decimal?

  • Report this Comment On September 09, 2011, at 10:38 AM, stopcrossselling wrote:

    The special report game is really getting old as you bait in the current subscriber(me), wasting my time thru a maze of links, i.e. looking for the names of two "favorite' stocks...which further requires signing up for something else... This seems petty and unprofessional. I am really rethinking my membership....

  • Report this Comment On September 09, 2011, at 12:52 PM, troytroy1 wrote:

    @stopcrossselling, if not Motley Fool, which other service would you consider becoming a member of?

  • Report this Comment On September 10, 2011, at 10:58 AM, kigali wrote:

    This map tends to show that the 2008-9 time is perhaps behind us, but we sure don't see that way....http://tipstrategies.com/interactive/geo-jobs-2011-04/

  • Report this Comment On September 10, 2011, at 5:31 PM, Glycomix wrote:

    I got it: the utilities like Con Ed and the Southern Company will make money despite the business environment. Bluechips with strong profit margins and high dividends like Coke and Intel are less likely to go down.

    However, I'm confused about the mortgage REITS. How can they make money when bank stocks are reeling because of Euro-debt in the PIIGS. Are or Aren't they also bound to mortgages?

    Are they alternatives to the banking system so they'll profit in a banking crisis?

    Please explain further about the mortgage REITS.

  • Report this Comment On September 10, 2011, at 7:46 PM, TMFRoyal wrote:

    Hi, Glycomix,

    I explain the case for Annaly further here. It's a part of my Rising Star portfolio.

    http://www.fool.com/investing/general/2011/05/31/rising-star...

    Foolish best,

    Jim

  • Report this Comment On September 12, 2011, at 12:30 AM, techy46 wrote:

    Mix up a portfolio of big cap high dividends like ATT, GE, INTC, MSFT and add a little growth like NVDA and then a little NLY to boast yield to 6% or more.

  • Report this Comment On September 13, 2011, at 11:39 AM, fbevansjr wrote:

    Depending on you tax bracket, it makes sense to hold municipal bonds and dividend paying stocks in your taxable portfolio. The dividend tax rate is 15% and withdrawals from a pension account will be at ordinary rates down the line (I know, you get to reinvest the taxes now due if held in a retirement account but we will never see this 15% rate forever). Paying the 15% now is like paying the tax on a Roth conversion to get it out of the way for future tax free withdrawals.

    Corporate bonds with interest taxed at high ordinary rates should be held in your retirement account.

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