Why dividend stocks top TIPS for income investing

SAN FRANCISCO (MarketWatch) — Dividend-paying stocks aren’t for widows and orphans anymore, and, for that matter, neither are Treasury bonds. As income-seeking investors know all too well, generating meaningful yield nowadays means accepting greater market risk and volatility.

Investing for income has become so challenging, it may be creating more widows and orphans than it saves. Buyers nowadays face a Hobson’s Choice that forces them to hold their noses and plunge. Yet one income strategy is capturing the attention of investors and investment advisers alike: Swapping inflation-protected Treasurys, or TIPS, for dividend stocks yielding 3% or more. Sounds like a slam-dunk. Except it’s not. Shifting money to stocks from bonds — even blue-chip, dividend payers — is a major decision that dramatically alters portfolio risk and volatility.

Apart from offering yield, dividend stocks are a totally different animal from bonds. Bonds return 100 cents on the dollar at maturity; stocks can lose money as long as you own them. Dividend stocks provide income, but they’re stocks all the same. In the 2008 market meltdown, SPDR S&P Dividend, an exchange-traded fund made up of top-drawer dividend stocks, lost 23% while the benchmark Standard & Poor’s 500-stock index fell 37%.

So if you pursue this strategy, your portfolio will become more volatile, and you’ll have to be proactive about risk management. “When someone says ‘I need more yield,’ my response is ‘You mean you need more risk in your portfolio,’” said Larry Swedroe, director of research for Buckingham Asset Management, LLC. “A dividend-paying strategy isn’t necessarily a bad one, but it’s much riskier. It’s not a substitute for fixed-income.” Dividend-paying stocks can be relatively resilient against rising inflation. Higher prices add to cash flow, which companies then can use to pad dividend payouts. But dividend growth is a weak foil for inflation unless you’re prepared to hold the shares for many years.

Before adding dividend stocks, understand another important caveat: Higher yield doesn’t mean you’ll get a higher total return. Stocks are volatile, dividends are cut or eliminated (think big U.S. banks post-2008), and companies go out of business. Accordingly, companies paying unusually high dividends are often out of favor or in trouble, so stick with well-known businesses with a wide “moat” — meaning they outdo competitors with products and services that appeal to a broad customer base.

Any company under consideration should have plenty of cash to cover the dividend, and a history of increasing the payout year after year. Many U.S. companies fit that bill. Oliver Pursche, president of investment adviser Gary Goldberg & Co., likes the dividend growth of corporate America bellwethers including Procter & Gamble Co. PG -0.39% , McDonald’s Corp. MCD -0.12% , Kraft Foods Inc. KFT +0.16% , Exxon Mobil Corp. XOM -0.12% and Intel Corp. INTC +0.15% “We’re focusing on companies and stocks that have a high dividend and a consistent history of raising dividends,” Pursche said. 

An easier way for most investors would be to buy a dividend-oriented exchange-traded fund or mutual fund. For example, high-grade dividend payers can be found by looking through the holdings of SPDR S&P Dividend SDY +0.44% , an ETF that reflects the S&P 500’s “Dividend Aristocrats” — companies that have raised dividends for at least 25 consecutive years. Or you could browse the 10 highest-yielding stocks in the Dow Jones Industrial Average DJIA +0.61% , the so-called Dogs of the Dow.

One ETF that includes many of those stocks is iShares High Dividend Equity Fund HDV +0.16% . But if you’re an income investor turning more to stocks, you’ll handle the transition better if you can mitigate volatility, said Mitch Tuchman, co-founder of MarketRiders, which helps investors build ETF portfolios.

 Try to find ETFs and funds that have portfolios with low “beta,” he added — portfolio-speak for securities that hold up better than a benchmark in bad markets (although they won’t rise as much in bullish periods). Tuchman suggests Vanguard High Dividend Yield ETF VYM -0.04% . which has cheap expenses and yields around 3.2%. The ETF has a beta of 0.9, compared to the Dow Jones U.S. Total Stock Market Index, which carries a beta of 1.0. So the ETF can be expected to move 9% when the benchmark moves 10%. The ETF has a “nice allocation among sectors, with companies that generate a lot of cash flow,” Tuchman said.

Tuchman also favors Vanguard Dividend Appreciation ETF, which, like SPDR S&P Dividend, is geared to companies with a record of increasing dividends. The Vanguard fund sports a 2.3% yield and has a 0.8 beta. By comparison, iShares Dow Jones Select Dividend Index Fund DVY +0.44% has a 3.6% yield and a beta of just 0.59 — less than 60% of the S&P 500’s volatility. But its expense ratio is higher than the Vanguard offering, and the portfolio mixes in more mid-cap stocks with the big-cap battleships.

Using dividend stocks for income and forgoing the inflation protection of TIPS is controversial and not for everyone. But for some investment advisers, it’s a sign of the times. “You don’t need inflation protection if there’s no inflation, and inflation is moderate,” said Harvey Rowen, CEO of investment adviser Starmont Asset Management LLC. “We would rather get something that yields more and go to TIPS when inflation gets worse.” Added Rowen: “The days of ‘buy and hold’ have left. We’re now in the days of ‘buy and manage.’”