Should I invest in dividend funds instead of bonds?

November 4, 2011: 11:52 AM ET

NEW YORK (CNNMoney) -- With interest rates so low and destined to go up, I'm wary of putting too much money in bond funds. As an alternative, I'm thinking of mutual funds that invest in dividend-paying stocks, particularly ones that consistently raise their dividends. My question: should I count the dividend stock funds as part of my stock allocation or my bond allocation? -- Ron

While I understand why some investors think dividend-paying stock funds are comparable to bond funds, it's dangerous not to distinguish between the two.

Both aim to provide investors with regular income, but that's about where the similarities end.

Switching to a dividend fund may even seem like a smarter choice since these funds carry yields that are equal to or higher than the anemic 2% or so that many bond funds are yielding right now. But anyone who replaces bonds (or, worse yet, CDs or money-market funds) with dividend-stocks is playing a dangerous game.

In no way should you consider dividend stocks or funds interchangeable with bond funds. They are entirely separate species that behave quite differently. The biggest distinction: dividend funds are far more volatile and have a much greater potential for loss than bond funds.

If you do decide to shift money to dividend funds, you should definitely consider that investment as part of your stock holdings, not part of your bond allocation.

To better understand why I'm so vehement about this issue, let's take a quick look at both investments from the vantage point of three key characteristics: their ability to produce income; their volatility, or risk level; and their correlation, or how they move relative to other parts of your portfolio.

Income: Although both funds can churn out regular income, a dividend fund's payments aren't anywhere near as sure as a bond fund's. That's because bonds are for the most part contractually required to make their interest payments, while dividend-paying stocks generally aren't. They have lots of leeway to suspend or cut dividend payments, as a record number did after the financial crisis in 2009. The Federal Reserve can even nix dividend increases as it did with some financial firms.

True, bonds can default on their interest payments (although the default rate is very low for highly-rated investment-grade issues). And dividend stocks have the advantage of possibly raising their payments over time. Ultimately, though, the income stream from bonds is much more assured.

Volatility: This is where you can really see that dividend funds behave more like stocks than bonds. To gauge the risk level of an investment, pros look to its "standard deviation," which is a measure of how much an investment's annual return varies from its annual average. The higher the standard deviation, the more volatile the investment.

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So, for example, if you plug the name or ticker symbol of the Vanguard Dividend Growth fund into Morningstar and then click on the Ratings & Risk tab, you'll see that the fund's standard deviation is 17.27 percentage points. That's a bit lower than the 21.25 percentage points for the Vanguard 500 index fund (which is a good proxy for the overall stock market). But it's nowhere near as low as the standard deviation for theVanguard Total Bond Market index fund (4.15) or Vanguard Short-Term Bond index fund (2.16).

But don't go just by this statistical measure. Take a look at how these funds fared during the 2008 market crash. Vanguard Dividend Growth lost 25.6% that year. While that was considerably less than Vanguard 500 index's 37% decline, it was a bloodbath compared to the 5.1% and 5.4% gains posted by the Total Market Bond and Short-Term Bond indexes, respectively

These results aren't particular to the Vanguard funds. They pretty much represent the experience of dividend and bond funds across the board. When it comes to volatility and risk, dividend funds clearly act much more like a stock fund than a bond fund.

Correlation: Income aside, people also invest in bond funds to dampen the ups and downs of an otherwise all-stock portfolio. Bonds have a calming effect because of their relatively low correlation with stocks, which is a fancy way of saying they don't move in sync with equities.

To measure the extent to which one investment zigs while another one zags, investment pros look at a measure known as the "correlation coefficient." The closer the coefficient between two investments is to 1, the more they move in unison. (If the coefficient is -1, they move in the opposite direction from each other.)

According to Morningstar's Principia software program, I found that over the past five years, the correlation between Vanguard Dividend Growth and the Vanguard 500 index fund was 0.98, which means they tend to move very closely together. The correlation between Vanguard Index 500 and iShares' Dow Jones Select Dividend ETF was a bit lower, but at 0.86 still pretty darn tight. Morningstar considers anything above 0.7 as high.

By contrast, the correlation between Vanguard Index 500 and Vanguard Total Bond Market Index was an extremely low 0.08. This suggests that the fund moves virtually independently of the stock market.

Reasonable people can argue about the extent to which investors should use correlation and other stats to build a portfolio. I think such stats can be helpful, although some people can go overboard.

But given the huge disparity in correlations, it's pretty clear that the more you shift money from bond funds to stock dividend funds, the more your portfolio's returns will be dictated by the stock market, and the less of a cushion you'll have to soften the blow of market setbacks.

One final note: Your concerns about rising interest rates are certainly justified. Although I don't know when or how much, I assume rates will climb at some point. And when they do, bond funds will take a hit.

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But despite all the talk of a bond market bubble, the pain bond investors might suffer isn't likely to be anywhere near as bad as what stock owners endure during market downturns. So as I've noted before, the right response to possible higher rates isn't to flee bonds, but to minimize the potential damage by building a diversified bond portfolio that emphasizes issues with short- to intermediate-term maturities. To top of page

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