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Can Dividend Stocks Replace Bonds?

Original post by Slav Fedorov of Demand Media

Investors buy bonds for high current income. High-yield dividend stocks can also provide current income but they cannot entirely replace bonds because of the fundamental differences between stocks and bonds. These variables present different risks and affect portfolio performance in different ways. Stocks are generally riskier than bonds. An all-dividend stock portfolio subjects an income investor to a higher degree of risk. It is better to have a mix of stocks and bonds that complement each other while reducing overall portfolio risks.

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Safety of Principal

A bond has a face value -- the principal amount to be repaid at maturity. If an investor holds a bond to maturity, he gets back the full face value of the bond. A stock has no maturity. The only way a stock investor can get his money back is to sell his shares to another investor. A bond can default, but even then, a bond investor may get back some principal in bankruptcy proceedings. A stock can go all the way down to zero and stock investors are usually wiped out in a corporate bankruptcy.

Degrees of Safety

Different bonds offer varying degrees of safety. U.S. Treasury bonds are safest because the principal and interest are backed by the full faith and credit of the U.S. Government. Corporate and municipal bonds have various credit ratings, which reflect the safety of principal and interest payments. An investor can choose bonds based on his risk tolerance. All stocks are risky. Most dividend stocks represent larger, more established companies that are considered less risky than smaller growth stocks, but even they cannot be guaranteed against occasional failure.

Safety of Income

Bonds pay regular interest that is set in dollars for the life of the bond. Dividends on stocks are not guaranteed: they can be reduced, omitted or suspended at any time, depriving an investor of income.

Advantages of Dividend Stocks

Although dividend stocks are riskier than bonds, they offer certain advantages. A corporation may increase dividends over time. Stocks that raise dividends tend to appreciate in price. An investor who owns a stock that increases dividends over time in effect owns an appreciating asset that provides rising income.

Preferred Stocks

Preferred stocks are considered a cross between a stock and a bond. Like bonds, preferred stocks provide high income in the form of dividends, which are fixed for the life of a preferred; but unlike bonds, preferred stocks do not have maturities. They do have call provisions -- the ability of the issuer to "call" or redeem them at face value after a certain date. For that reason, unlike common stocks, preferred stocks have limited appreciation potential, because if a preferred stock can be called at a particular price, investors would be reluctant to pay a premium for it. Many preferred stock dividends can also be cut or suspended. If a preferred stock issuer defaults, preferred shareholders are behind bondholders in their claims against company assets, so preferred stocks are also riskier than bonds.


                   

References

  • "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
  • "The All-Season Investor"; Martin J. Pring; 1992

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.


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