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

Bond Portfolio Share

Investors < 40 years

Investors 40 to 60

Investors > 65 years

More than 50%




31% to 50%




11% to 30%




1% to 10%









Based on this data, then, it's no surprise that it's been a very rocky year for investors of all ages. While the S&P 500 is down more than 10% since last September, the aggregate U.S. bond market has 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 need more fixed income in their portfolios -- 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:


Equity Funds

Bond Funds

Year-to-date inflows

($87 million)

$212.8 billion

Source: as of Aug. 26, 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, saw $1.26 billion in net inflows in the past four weeks alone -- and they've rallied some 40% year to date. Companies with junk bond ratings include casino operator MGM Mirage (NYSE:MGM) and Ford Motor (NYSE:F).

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.

Know the rules before you play
Jumping into bonds isn't 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 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.
  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 but 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 with not only yields superior to 10-year Treasuries but also with plenty of cash to fund and grow their payouts. Here are just a few:


Dividend Yield

Free Cash Flow
Payout Ratio

5-Year Dividend Growth Rate

Northrop Grumman (NYSE:NOC)




Caterpillar (NYSE:CAT)




Johnson & Johnson (NYSE:JNJ)




Coca-Cola (NYSE:KO)




Procter & Gamble (NYSE:PG)




Source: Capital IQ as of Sept. 18, 2009.

Each of these stocks has a long 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 3.44% yield per year on your investment, the same investment in one 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 dividend-paying stocks.

Finding the right mix
If the market volatility of the past year 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 and, like stocks, 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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Motley Fool Pro analyst Todd Wenning would like to congratulate the nationally ranked Elder Panthers (Ohio) on their 3-0 start. He owns shares of Procter & Gamble. Coca-Cola is a Motley Fool Inside Value recommendation. Johnson & Johnson, Coca-Cola, and Procter & Gamble are Income Investor recommendations. The Fool owns shares of Procter & Gamble and has a disclosure policy.