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Taxable Bonds: The New Dividend Play |
May 13, 2009 By Dan Wiener, Editor, Independent Adviser for Vanguard Investors |
Dan Wiener
Daniel P. Wiener is America's leading expert on investing in Vanguard mutual funds and is editor of The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard. The Adviser is a five-time winner of the Newsletter Publishers Foundation's Editorial Excellence Award.
Also From Dan Wiener
Free Reports by Dan Wiener
Stock market investors are pretty clear about the tradeoffs between risk and return when they invest, partly because swings in the stock market can be quite broad. The more you put into the stock market, the greater the risk to your overall capital.
Stocks and stock funds are primarily plays on capital. While dividends do have their place, and can account for a significant portion of a stock's return in some cases, the real mover in the stock market is prices — plain and simple. I should note that currently, the dividend yield on the S&P 500, or the Dow Industrials, is quite good on a relative basis, but not sumptuous on an absolute level.
As long-time GNMA manager Paul Kaplan, now retired, once described it to me, investors who purchase long-maturity bonds, or funds, are reducing their income risk but trading it for capital risk. A long-term bond investor receives a certain level of income month after month because his or her bonds have long maturities and just keep paying out the same income month after month (or every six months, depending on their payment schedule).
But of course there is fairly decent principal risk on a long bond, because over the time you are holding it, the price can move dramatically up or down, depending on how interest rates are changing. And of course, there's always ample time for the borrower to default entirely.
A short-term bond investor takes lots of income risk but little capital risk. Short-term bonds, by definition, mature fairly quickly and hence their prices can remain fairly stable. Even if they bounce around a lot, the investor knows they will mature relatively soon, and the closer one gets to the maturity date, the lower the volatility and the closer the bond will trade, in price, to par, or its face value.
But because that maturing bond's principal must be re-invested, the short-term bond investor takes on much more income risk. In a falling interest rate environment, that matured bond's principal may have to be reinvested at lower rates.
