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Why Dividends Beat Bonds in My Book

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How are you planning to fund your retirement?

"Save a big pile of money beforehand" is the answer I usually hear, especially from younger folks. And it's not a bad goal. But even if you're diligent about saving every month, it's something of a long shot, thanks to Mr. Market's occasional tendency to moodiness.

Fortunately, it's not too hard to save a decent amount before you leave work for the last time, and to do it with investments that will give you an income stream in later life. And my money is (literally) on the great benefits of dividend stocks, despite the concerns of some folks, like my colleague Dan Caplinger, who argues that dividend stocks are no replacement for bonds.

Why dividends should fund your retirement
It's no secret that dividend stocks have become popular with retirement investors in recent years. And with good reason: The best dividend stocks, those of blue-chip companies with a long history of raising their dividends every year, have advantages for retirement investors that few investments can match.

The biggest advantage is that the dividends can be reinvested for extra growth -- a particularly powerful technique to use in a tax-advantaged account like an IRA -- or taken as income once you're in retirement.

That added growth can be a big deal. One of the other key benefits of dividend stocks -- that they're less volatile than growth stocks, and thus less likely to take big losses when the market takes a swan dive -- comes with an implicit downside: Their prices probably won't go up as much during roaring bull periods. But reinvested dividends can help make up the difference.

For instance, take a look at Southern Company (NYSE: SO  ) , a very well-managed electric power provider. Southern's stock has done better than many utilities', but it's no moon rocket. If you'd bought it 10 years ago, you'd be up about 66% now. That's not too shabby, but it pales in comparison to the 167% return you'd have if you had reinvested the dividends.

That return puts it in a different league, a league with other great dividend stocks, like pharma giant Johnson & Johnson (NYSE: JNJ  ) , which could be about to raise its dividend for the 50th consecutive year. Or 3M (NYSE: MMM  ) , the famous Scotch Tape and Post-It king, which is really a well-diversified industrial giant that has raised dividends for 53 years running. Or Philip Morris International (NYSE: PM  ) , a big-dividend (3.5% yield) tobacco giant that operates only outside of the U.S. and thus isn't exposed to the regulatory risks facing Big Tobacco here.

But about those bonds
In the new issue of the Fool's Rule Your Retirement newsletter, advisor Robert Brokamp argues, like Dan, that bonds have gotten a bad rap. Bonds, he argues, aren't nearly as vulnerable to Mr. Market's mood swings, can help lower the risk level of your overall portfolio, and the income they provide can help your portfolio grow -- and provide for your expenses after you retire. And unlike dividends, a bond's yield won't be cut if the company hits a rough patch.

Sound familiar? It's true that well-chosen corporate bonds can offer some of the same benefits you'd get with dividend stocks. But there are some downsides, starting with a biggie: Bond prices fall as interest rates rise. With interest rates still near historic lows, that's likely to be a problem in the future, unless you plan on holding all those bonds to maturity.

More to the point, though, is that bonds are unlikely to give you the growth of stocks over time. I was just looking at a bond issued by Ford (NYSE: F  ) , the resurgent American automaker, that would yield just under 6% if you bought it today and held it to maturity in 2022. That's better than the yield on most dividend stocks, but unlike stocks, that almost-6% is all you're going to get if you hold the bond to maturity.

Still, it's true that bonds can have a useful role in your retirement portfolio, and the debate over bonds versus dividend stocks is one I'd encourage you to explore. Check out the new issue of Rule Your Retirement for the full scoop.

If you're not a subscriber, that's not a problem! You can get full access to all of this month's great content, including all of these recommendations, with a no-hassle, 30-day free trial. There's absolutely no obligation to subscribe -- click here to get started now.

Fool contributor John Rosevear owns shares of Ford. Follow him on Twitter at @jrosevear. The Motley Fool owns shares of Johnson & Johnson and Ford. Motley Fool newsletter services have recommended buying shares of Philip Morris International, Johnson & Johnson, 3M, Southern, and Ford, as well as creating a synthetic long position in Ford and diagonal call positions in 3M and Johnson & Johnson. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (46)

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 April 06, 2012, at 3:19 PM, GregLoire wrote:

    You can also reinvest the bond interest payments, so I'm not sure why reinvestment would be considered an exclusive factor for dividend-paying stocks.

    Ultimately the big advantage of stocks (dividend-paying or otherwise) is that on average they go up more than bonds because the underlying asset is more productive than simply holding debt.

  • Report this Comment On April 06, 2012, at 4:55 PM, alan0101 wrote:

    I wouldnever invest in PM, the fact that it does its harm abroad and not at home is immoral, at best.there are plenty of decent companies around to make money with. Why single out these cretins.

  • Report this Comment On April 06, 2012, at 6:06 PM, bugahamike wrote:

    Leave the cretins to me then Alan. An investment in Altria Group several years back, could change your mind as to what is harmful and what is a Blue Chip stock.

    Forever Hold

  • Report this Comment On April 06, 2012, at 6:50 PM, Groovetoon wrote:

    Anything to make a buck eh bug? Good for you Alan. I have the same feeling for Monsanto.

  • Report this Comment On April 07, 2012, at 9:29 AM, rpguy4 wrote:

    What about REITs that pay a very generous dividend ? I have owned AGNC and NLY for the past year and have made a nice quarterly dividend.

    These REITs pay double or triple the dividend of

    the blue chips mentioned in this article, and to me are far less volatile in price.

  • Report this Comment On April 07, 2012, at 11:08 PM, CluckChicken wrote:

    @rpguy4 - REITs can take quick swings depending on what and where the group works. For example if the group works mostly with rental commercial properties they could take a hit if a large company moves out of an area leaving a sizable about of office space on the market. Just something to watch

    If you are thinking about bonds but not sure how to go about getting or how to properly research them you could look at ETFs like HYG (7.3% yield & .5% cost) or JNK (7.4% yield .4% cost) or PHB (5.6% yield .5% cost). The dividend amounts tend to move with the changes of the rates in the held bonds, as one would expect. With these you can diversify your overall portfolio by basically adding bonds but can also take full advantage of DRIPs (depending on broker). Just something to consider.

  • Report this Comment On April 13, 2012, at 12:30 PM, WineHouse wrote:

    I've got NLY also -- but with my eyes wide open. I consider it a big risk (and the nice current yield is the pay I get for taking that big risk). Do you know how NLY gets its free cash from operations (the $$ from whence cometh the dividends)? Basically they manipulate their mortgage-backed security holdings to capture the spread between short term and long term debt (that's an oversimplification but good enough for now). That's a very dicey business! Hey, just "mortgage-backed security holdings" should be enough to send a couple of trepidation shivers down your spine.

    Not only am I aware of the risk I've taken with NLY, I have gotten burned in the past with similar REITs that don't actually own properties but rather "own" debt of one sort or another. I used to own shares of a "venture-capital REIT" that collapsed during the banking fiasco simply because of the drying up of commercial credit -- they were bought out for pennies on the dollar by Ares Capital, a similar but larger and stronger venture-capital REIT, and after a while I actually added more Ares to my position because Ares itself had been doing well. Ares is still paying out well in distributions but the market price has dropped since I added more shares. It was after Ares dropped that I added some NLY to the mix. So, am I an idiot? Well, probably. But these are "calculated risks" that I'm taking with the full knowledge that things could go south not only for the market value, which is of less concern to me, but also for the income, which is my major concern. And all together these oddball REITs that don't actually hold real properties represent only a small fraction of my IRA. It's "gambling" money, a calculated risk, with fingers crossed and hands desperately searching for a crystal ball.

  • Report this Comment On April 13, 2012, at 4:20 PM, shbeavers wrote:

    The article didn't mention that inflation is a key problem with fixed income investments like bonds. Each year the same number of dollars comes in but you can buy less with them. To overcome this decline in purchasing power you must reinvest some of the income to increase the dollars coming in the next year - and do so repeatedly for each subsequent year.

    To overcome the approximate 3.5% average inflation rate of the past century you need to increase your investment capital by 3.5% each year. This means if you own bonds yielding 4%, you get to spend just 0.5% of the income and reinvest 3.5% to offset next year's inflation.

    Plus taxes on the entire 4% come out of the 0.5% you keep to live on unless you're IRA investing. The MINIMUM amount you need to earn TO BREAK EVEN factoring in taxes is 3.5% x (1+ tax rate). So if you pay 20% in taxes, you need to earn 4.3% just to break even on taxes and inflation before you can keep a dime to live on. Oops, a 4% bond is actually a loser! You do get to spend 80% (1-tax rate) of what you earn above 4.3% so it takes a 7% bond to get a disposable income of ~3% (2.96%).

    Good dividend companies grow their dividends for you each year. It's not too hard to pick a portfolio of dividend stocks with an average dividend growth rate that exceeds inflation. So maybe you accept a dividend yield of only 2% - but you get to spend the entire 2% to live on rather than just the sliver of income left over after reinvesting to offset inflation. There are plenty of great conservative dividend stocks yielding much more than 2%. And any average portfolio dividend increase above the rate of inflation will provide more spending money each year.

    Yes, capital values may fluctuate with stocks but they will with bonds as well unless you wait until maturity. Reserves that you can't afford to take chances with should not be invested in either. If you're looking for an income stream to live on, dividends trump bonds.

  • Report this Comment On April 15, 2012, at 7:23 PM, rovobo wrote:

    dnp select income has been paying over 6% for ten yrs. or more I own it in my IRA and reinvest my dividends monthly without drawing down my principle, thereby earning almost 7% +/- for a long time.

    rovobo

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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing for the Fool since 2007. A lifelong car nerd, his current daily driver is a Cadillac CTS-V.

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