With interest rates as low as they are, it's not surprising that people are looking for other ways to get paid. A large number of income oriented investors are beginning to take a look outside of their comfort zones, to find investments that yield more than your average bond. In a lot of cases, they may not realize the amount of risk they may be taking on.
However, in portfolio construction there are, unfortunately, few fixed income alternatives. There is even a coined phrase for this predicament: TINA—short for There Is No Alternative.
Don't be hypnotized by more yield
Against this backdrop, it can look quite attractive to consider swapping bonds out for dividend-paying equities to generate more cash flow. At a glance, bonds and dividend-paying equities may appear interchangeable because they both yield cash flow for investors. But, does it make sense?
At MD, we are proud of our two dividend solutions: the MD Dividend Growth Fund and the MDPIM Dividend Pool. Assets are invested in high-quality companies with solid business models that allow them to pay out their free cash flow consistently over time. Both pay a healthy dividend and investors get an additional boost from the preferential tax treatment dividends receive.
However, dividend-paying investments like the two aforementioned funds are substitutes for other equities, not for bonds, GICs or cash. The risks you assume when investing in dividend-paying equities is greater than the risks you assume when investing in fixed income securities—and that's the bottom line.
Under the hood: Stocks and bonds have completely different risks
When you invest money in bonds, you can be reasonably sure that your funds will still be at your disposal when the bond's term is up. $100 invested today will still be worth $100 three to five years from now (or longer) when the bond matures. The same cannot be said for equities, at all.
Even the most stable companies experience fluctuations in their stock prices. Markets have been rising in the past few years, which can make people forget, but recessions happen, markets do correct and they do occasionally crash. This is when bonds can offer protection for your portfolio.
When presented with the choice of investing in a bond yielding 1.6% or a stock with a 3% dividend, investors are obviously going to be tempted by the higher yield (and let's not forget about the preferential tax treatment). In reality though, there is always the chance your investment in that stock will be worth half (or less) of what you paid for it.
Meaningful diversification can help with this problem
In the future, if we see increased market volatility or a recession, or if we see interest rate sensitive securities coming under pressure, dividend funds will likely go down in value to some extent. We are generally expecting lower returns for the next ten years than what we've experienced in the past ten.
Large, dramatic loses are not something that would typically happen if you were partially invested in fixed income. It is, however, a predictable outcome that your portfolio will decline during a market correction if all of those assets are invested in equities.
Income wise, you may still be earning a few percentage points above what you'd earn if you were invested in fixed income, but if markets go south, there is a chance your dividend stock's underlying value will decrease as well. While portfolios will usually recover from market fluctuations, it takes time, time that a lot of income-seeking investors don't have.
Dividend-paying equities have their own purpose
So what role should dividend-paying stocks play in the average portfolio? Generally, they're used to make up the equity component of a portfolio for slightly more conservative investors. They are typically used when the investor needs cash paid out regularly, or when investors are seeking something more stable than a general basket of equities. Companies that pay dividends are typically mature (their proven business models allow them to continue paying regular dividends), but they're generally not equipped to grow rapidly in value.
Dividend-paying equities are a suitable substitute for other equity components in your portfolio. They can be more defensive, but they are not a bond replacement. They look relatively attractive right now if you're only looking at yield, but they don't always hold up when you peel back the layers and look at the underlying risk. Bonds, conversely, won't pay a lot of money, but they can still provide a safety net for your portfolio when markets are volatile or declining.
For investors who are seeking yield, we recommend that you speak with your MD Advisor to understand the risks of different options and your own appetite for risk. It may be useful to reassess your ability and willingness to take on additional risk, and can help to make sure that your portfolio is properly constructed.
An MD Advisor* may also know about tools and products you can use to possibly improve your returns without drastically increasing the amount of risk your portfolio is exposed to. We recommend that you learn more about your options and taking a calculated and fully-informed approach.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.