Dividend strategies keep attracting assets

(MoneyWatch) One thing we can all agree on is that the Federal Reserve has been very successful in driving interest rates down. Unfortunately, while helping the economy recover, they have effectively thrown senior citizens (who often depend heavily on interest income) and savers in general under the proverbial bus.

For many, safe fixed-income investments no longer generate the interest income they need to meet expenses. This is causing many investors to take on incremental risk in their search for greater yields. All of the typical strategies investors pursue in their search have flaws in them, flaws that can do serious damage. To help you avoid making a mistake, we'll review the typical investment strategies and point out the flaws.

Why you should be wary of stocks that pay dividends
The dangers of dividend-paying stocks
Don't rely on dividend strategies to pick stocks

In their search for greater yield investors generally follow one of three paths, often combining them:

Longer maturities

Many investors increase the maturity of their holdings, earning the term premium. Unless the bonds are TIPS, this results in taking on more inflation risk. And for seniors, this is often the greatest risk they face. Longer-term bonds may be appropriate for young investor, for whom deflation can often be the greatest risk (as it puts their labor capital, which is a typically a large percentage of their "assets" at risk).

Riskier bonds

Some investors move from safe government bonds and perhaps highly-rated corporate bonds (AAA/AA) to riskier corporate credits, including "junk" bonds. In doing so, investors often make the mistake of confusing yield with return. A higher yield is always indicative of greater risk -- with the risk being you may not even get your principal back, let alone earn the higher yield. One of my laws of prudent investing is that it takes a lot of interest to make up for unpaid principal. And the historical evidence is that corporate credit risk hasn't been well rewarded -- after taking into account losses from defaults and early redemptions from calls, investors have earned very little of the credit premium.

For example, for the period 1926-2011, long-term (20-year) corporate bonds returned 6 percent, only outperforming long-term Treasury bonds by 0.3 percent and earning just a small percentage of the credit spread. More importantly, the results should be viewed from a portfolio perspective.

• 60 percent S&P 500 Index/40 percent long-term corporate bonds: Return 8.8 percent with annual standard deviation of 13.2 percent
• 60 percent S&P 500/40 percent long-term government bonds: Return 8.8 percent with a standard deviation of 12.8 percent

Investors weren't rewarded for taking more risk. And in years like 2008, when stock risks show up and investors need the stability of their bonds to keep them "sane," Treasuries outperform corporates. In 2008, while long-term Treasuries rose almost 25.8 percent, long-term corporates rose just 8.8 percent.

We see similar results when we look at intermediate-term bonds (five-year Treasuries and the Barclays Intermediate Credit Bond Index). For the period 1973-2011 (the longest for which we have data), the 60/40 portfolio using Treasuries returned 9.4 percent with an annual standard deviation of 11.6 percent, while the similar portfolio using corporates returned the same 9.4 percent with an annual standard deviation of 12.5 percent.

Again we see both that higher yields didn't translate into higher returns and that credit risk wasn't well rewarded. We also see that in 2008, five-year Treasuries returned 13.1 percent, while intermediate corporates actually lost 2.8 percent. Note that these results don't consider the costs of the strategies. The first advantage of Treasuries is that because there's no credit risk you don't need to diversify risk. That allows you to avoid paying a mutual fund's expenses. The second advantage is that if you use a fund, the Treasury market is far more liquid, so Treasuries have lower trading costs than do corporates. The third advantage applies to taxable accounts -- income from Treasury bonds is exempt from state taxes.

Dividends

Invest in stocks that pay high dividends (including utilities and master limited partnerships), exchanging interest income for dividend income. Unfortunately, this strategy has several serious flaws.

To summarize, dividend strategies aren't substitutes for safe fixed income. They bear stock-like risks, and their risks show up at the wrong time -- when your stocks are being hit by a financial storm and you need safe bond investments to dampen the risk of the overall portfolio to an acceptable level (as in 2008). In addition, because of their high correlation to stocks, you lose much of the diversification benefits you receive from safe bonds -- benefits that produce a diversification return (or what some call a rebalancing bonus, in which the portfolio's return is greater than the weighted average return of its components) if you have the discipline to rebalance your portfolio.

The bottom line is that you would be better off not using any of these strategies to drive more yield into the portfolio. If you need more yield, what you are really saying is that you need more risk in your portfolio. Yet most investors don't acknowledge that. If you do need more risk in your portfolio, along with the higher expected returns that go with it, instead of stretching for more yield you should consider either increasing your stock exposure or (and this is my preference) increasing your exposure to the size and value factors. Investors have been better rewarded for taking those risks than the other types of risks we have discussed.