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Income Investors: Be Careful When Substituting Dividend ETFs for Bonds


Investors unhappy with the current low-yield environment have taken a larger position in dividend yielding stocks and exchange traded funds, even at the expense of their fixed-income holdings.

While stocks may provide more attractive yields, investors could be overexposed to risky assets. In other words, conservative investors substituting dividend ETFs for bonds may end up taking on more risk than they should.

Joe Davis, Vanguard’s chief economist, in a Morningstar article emphasized that “dividend-paying stocks are not bonds.”

If investors are knowingly leaning toward dividend stocks, they will have a more equity-based investment portfolio and should be wary of greater short-term volatility or periods of risk aversion, especially in the months surrounding the fiscal cliff. [Dividend ETFs and the Fiscal Cliff]

It’s a simple point — stocks are historically more volatile than bonds. However, it’s worth keeping in mind amid the mad scramble for yield.

Vanguard’s Davis says stocks should outperform bonds over the long run, and valuations would suggest that that’s a reasonable assertion.

“However, that comes at a cost of bearing volatility during periods of risk aversion, much like we had this past summer and can very well be in store for next several months,” he added. Davis urged investors to have their eyes wide open and understand the risks of using dividend stocks in place of bonds. [Is There a Bubble in Dividend ETFs?]

He’s concerned “we’re seeing from some investors on, say, a dividend portfolio or an equity-like portfolio, they’re equating that as similar to a yield on a bond portfolio, and those are markedly different characteristics in terms of what they may mean for expected returns,” Davis added.

Even within the fixed-income market, investors are stretching for yield.

“We clearly are seeing that in the high-yield fixed-income arena, both in corporates as well as municipals,” Davis said. “Again, I think many investors are doing it with eyes wide open and perhaps are willing to take on greater interest-rate or credit risk. However, I do hope that they do realize that they’re doing so in the process.”

For more information on dividends, visit our dividend ETFs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.