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Income Investors Face Risk, Reward

Jeff Brown

Investors can look for steady income in many places. The most common are bonds, which pay interest through coupons, and stocks which pay dividends.

In both cases, earnings are measured with "yield," a year's income divided by the security's current price. That makes it easy to compare. Stocks in the Standard & Poor's 500 index currently yield an average of just under 2 percent, while the 10-year U.S. Treasury note yields nearly 3 percent.

But the two types of yield are really quite different, and experts say it's hazardous to fixate on yield alone, even if income is the investor's chief goal. Stocks are more volatile, and bonds, though considered safer, can lose money, too.

"An income-focused investor should hold a portfolio of both bonds and high-quality dividend-paying stocks," says Jenny Kelber, assistant professor of economics and business at Saint Anselm College in Manchester, New Hampshire.

Bonds, especially ones with long maturities, lose value when rising interest rates make newer bonds more attractive, and stocks are subject to gyrations of the market as demand waxes and wanes. Owning both, she says, assures steady income as conditions change, and holding for the long term evens out the ups and downs.

[See: 9 Dividend Stocks to Sell in May (and Go Away).]

"The breakdown between the two asset classes is a decision that depends upon individual investor goals and risk tolerance," she says. "Further, market timing is notoriously difficult. It's generally wise to follow a buy-and-hold strategy."

So, how do you sort it out to decide which asset class has the combination of risk and reward that suits your situation?

First, experts say investors should keep in mind that both types of security entail a risk related to how yield is calculated, since the income is a fairly steady figure while stock and bond prices can change quite suddenly. If the price tumbles due to changes in supply and demand, the yield can spike to what looks like a very generous level. A security that paid 3 percent, or $30 a year per $1,000 invested, would suddenly be paying 4 percent if the security's value fell to $750.

But an investor fixated on high yield could overlook the underlying risk of a falling price wiping out many years of interest or dividend earnings. That loss could be overcome with a price rebound, but that might take years or never occur at all. Also, a soaring yield could be followed by a reduction or elimination of the stock dividend, or by a bond default, when the issuer fails to make its promised coupon payments or to return investors' principal when the bond matures.

So with either security, the investor is wise to assess the issuer's current health and prospects.

With a bond, that is done by looking at ratings from credit agencies, or by investing in government securities that can fluctuate in price but are unlikely to default.

With stocks, the investor seeking dividend earnings should consider the same factors that would go into any stock purchase, says Patrick Healey, president of New Jersey-based Caliber Financial Partners.

"When it comes to stock yield, there are a number of different factors that need to be considered including strength of company earnings and cash flows, the sectors they operate in, the overall growth of the economy, as well as the dividend payout ratio, which is often overlooked."

That is the percentage of earnings paid out as dividends. The lower the figure the less likely a drop in earnings would lead the company to cut or eliminate the dividend.

For either type of security, the easiest way to shop is to find a mutual fund or exchange-traded fund that only owns high-quality securities screened by the managers.

[See: 7 Bond Funds to Buy as Rates Rise.]

While credit quality is a good factor in picking bonds and bond funds, investors opting for stock dividends can look at the firm's dividend-paying history, says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. The best prospects are companies that have a steady history of growing earnings and increasing dividends, he says.

"One need look no further than stocks that have increased their dividends for many consecutive years to find good, safe candidates for dividend investing," he says. "Some refer to these as ruler stocks because if you laid down a ruler on a graph of dividends over time, the ruler would point to the northeast and most of the points would be very close to the ruler."

A simple way to find such stocks is to search online for the "Dividend Aristocrats," a list of firms that have raised dividends every year for at least 25 years. Some funds specialize in these stocks.

The investor should also keep in mind that stocks and bonds generally serve different functions in the portfolio, says Anthony Parish, director of quantitative strategies at Sage Advisory, located in Austin, Texas.

"Stocks primarily provide growth of capital, and potentially some income, though volatility can be all over the map," he says. "Bonds primarily provide income, with lower volatility than stocks. Comparing stocks to bonds is like comparing apples to oranges."

While he prefers to focus on long-term investment strategy rather than current market conditions, he says that the two asset classes behave differently when interest rates are rising, as many economists expect over the next year or longer.

"Generally, interest rates and stocks tend to be positively correlated," he says. "In other words, when stocks rise, rates tend to rise, and vice versa."

Bonds tend to lose value when rates rise, because investors would rather buy newer bonds that pay more, he says. That's why investors are wise to own both.

[See: 9 Financial Stocks to Buy for the Dividends.]

"When one increases in value, the other tends to decrease, and vice versa," Parish says. "Obviously, this relationship is unreliable in the short term, but it should generally persist. The optimal mix should depend on whether the investor primarily needs capital appreciation or income."

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