In a prolonged low-interest environment bonds become less attractive since their dividends may be puny.
In addition, bondholders must be aware that interest rates will not stay low forever and when they do rise existing bonds will become less valuable because of lower dividend rate.
So many investors look for a higher yield in dividend paying stocks and this strategy has some appeal.
However, bonds and the many dividend paying stocks differ in some significant ways and investors would be wise to understand the pros and cons of each.
It probably does not make sense to replace all your bonds with dividend paying stocks, as it would not make any sense to replace all your dividend paying stocks with bonds.
Let's look at the strengths and weaknesses of bonds and dividend paying stocks to determine whether this the strategy you can use in some form.
Bonds appeal to many investors as a way to help offset the volatility of their stock holdings. Bonds are also a way to preserve capital if that is important to you.
If you plan to buy a bond and hold it to maturity, you are not really too worried about rising interest rates. The fault in this strategy is that your money could be earning more by buying newer bonds at higher rates than sticking with your older bond.
However, if you want to sell your bond after interest rates have risen you'll discover that it must be sold at a discount to match market rates.
As investors near or enter their retirement, they may have a focus of preservation of capital rather than growth. If you invest $10,000 in a highly rated bond for 5 years the odds are very very good at the end of 5 years your $10,000 will be there.
In most cases the bonds pay a fixed interest rate and the higher the quality of bond the lower the interest rate will normally be.
You're trading lower interest rate for higher security. You can find bonds that pay a higher rate if you're willing to buy an issue that is not as creditworthy.
Dividend paying stocks
Dividend paying stocks are fine choice for many investors looking for some current income from the dividends and as a bonus possible appreciation of the stock price.
Dividend paying stocks tend to be less volatile than other stocks primarily because they are usually very well off financially, thus the ability to pay a dividend.
However they are not shielded from volatility and if the market and economy turns against them you can suffer a loss area
Following our example above if you invest in $10,000 in dividend paying stock for five years you will not know how much it will be worth then - it could be more and it could be less.
The possibility of loss makes dividend stocks slightly more risky than bonds. However even a low-interest environment there is are good dividend paying stocks that pay substantially more than bonds.
Which should you choose?
It is probably not a question of should you own dividends paying stocks or should you own bonds. The better question may be what percentage of dividend paying stocks and what percentage of bonds should make up your portfolio.
If you're willing to accept slightly more risk for a higher yield then a fixed income portfolio more heavily weighted towards dividend paying stocks would make sense for you.
However, if your primary concern is preservation of capital and that is very important to you then you probably want us stick with a portfolio that is more heavily weighted with high quality bonds.
In either case is a matter of balancing your investment priorities, your tolerance for risk and the tools you have available.