3 Income Investing Myths

If interest rates rise, where should bond investors go for protection? Will individual bonds, dividend-paying stocks, or cash be safest?

Christine Benz 07 November, 2014 | 13:50
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It's late in a decades-long bond rally, and it's safe to say that the current, ultralow interest-rate environment is messing with our heads. 

Who, at the outset of 2014, would have guessed that bonds would continue to rally? And fewer still predicted that long-term US government bonds, deeply unloved by most investors for their extreme sensitivity to interest-rate changes, would be the among best-performing categories this year, gaining more than 20%. With interest rates so low, you need to whip out an electron microscope to see the yield on your bond fund, never mind the return you are getting on cash. 

Ongoing low interest rates have left many income-seeking investors scrambling for yield and have challenged the conventional wisdom about what an in-retirement portfolio should look like. The low rate environment has also given rise to a lot of questions. If interest rates rise, where should bond investors go for protection? Will individual bonds, dividend-paying stocks, and/or cash be safer than the core bond funds that so many investors have been counselled to hold?

The answers to these questions aren't clear-cut, which in turn leaves plenty of room for confusion. Here are a few of the myths that are swirling around income-producing securities right now. Granted, not all are out-and-out falsehoods; some of them may hold up in certain situations. But at a minimum, investors shouldn't accept them without first thinking through their own situations, especially their time horizons. 

Myth 1: If Rates are Going to Rise, Buy Individual Bonds Rather than Bond Funds

If you buy an individual bond at the time of issuance and hold it until maturity, you will get your money back in the end, as well as your interest payments along the way--assuming you bought the bond from a creditworthy issuer. By contrast, you won't always get the same amount back from your bond fund that you put in. For example, say you put money into a long-term bond fund and interest rates shot up by two percentage points between the time of your purchase and the time you sell, it's very likely the bonds in the portfolio would have declined in value over your holding period, even if the yield on your fund perked up. Of course, the opposite can also happen; rates can go down, as they have this year, and the bond-fund holder may see his or her principal value grow, even as the fund's yield has declined.

For some investors, that might seem like an out-and-out indictment of bond funds, especially given the likely long-term direction of interest rates: up. But while buying and holding individual bonds may help you circumvent one type of risk that the bond-fund holder would confront head-on, you could still face an opportunity cost, which is also a risk. If rates head upward and you're determined to not take a loss on your bond, you're stuck with it until maturity.

Meanwhile, as the various bonds in a fund's portfolio mature, the bond fund can take advantage of new, higher-yielding bonds as they come to market. That helps offset any principal losses the fund incurs as rates go up. Individual bond buyers may also face sizable trading costs.

Myth 2: Dividend-Paying Stocks are Safer than Bonds

In a related vein, some investors have sold bonds altogether, replacing them with dividend-paying stocks. With dividend payers, you're not only able to pick up some income, but you may also gain some capital appreciation if the stock increases in value over your holding period and the company may also increase its dividend over time. For people with longer time horizons, dividend-paying stocks--and perhaps all stocks—are a good bet, in that stocks have generated a positive return in rolling 10-year periods roughly 95% of the time. 

But as with buying individual bonds, there's a trade-off involved. Of course, stocks, even high-quality dividend payers, have much higher volatility than bonds, making them potentially poor choices for investors who may need to pull their money out in less than 10 years.

Moreover, stocks won't be impervious to interest-rate increases, and because investors have been increasingly using dividend payers as a bond substitute, they may be vulnerable to selling if rates head up and bonds become a more compelling alternative.

Finally, it's worth noting that companies can cut their dividends in times of distress, as was painfully apparent to many dividend-dependent investors during the financial crisis.

Myth 3: Cash Is Safer Than Bonds

This one is, of course, technically true. After all, cash deposited in accounts protected by the Financial Services Compensation Scheme is protected, and that's not an assurance you have with any sort of bond fund.

If you have money you can't afford to lose because you're going to use it to pay next year's school fees, your tax bill, or your mortgage, it's best not to nudge up the risk spectrum and into bonds. That holds true regardless of the prospective direction of interest rates. 

But if your time horizon is longer, sinking too much into cash means that you're virtually guaranteed to lose money once inflation taken into consideration. Investors might say that they'll steer their bond money to cash for only as long as it takes interest rates to go back to more meaningful levels and the threat of an interest-rate shock has subsided.

But how will they know when that is? As with any market inflection point, there won't be clanging bells letting you know it's OK to get back into bonds. Instead, a better strategy is to match your time horizon to the duration of your bond holdings: very short-term assets in cash, intermediate-term assets bond types, and long-term assets in a diversified equity portfolio.

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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