Bond funds vs. Dividend Funds?

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hoangtrunglien
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Bond funds vs. Dividend Funds?

Post by hoangtrunglien »

I was at an event this evening with my father in law. We never talked finance before but tonight it came up.

He is at a place where he needs to average about 4% on his current holdings, annually, (without a need to invest any new money) to hit his needed income, and well exceed his projected life expectancy.

He currently owns some blue chip stocks with a long history of paying dividends, and many muni bonds.

His goal is to have something which produces income annually and he doesn't much care about the unrealized gains or losses on his initial investment. To him, he's using the bond to accumulate money a couple times per year, which he will not reinvest at a certain point in the future, and hold the bond until maturity and buy a new one.

Questions:
If he doesn't care whether the unrealized value of the bond drops, might he be better off buying a bond fund? He's not planning to cash it out and just wants the yield each year?
Or what about an index fund with all dividend paying stocks stocks stocks?

Would anyone be able to explain the different risks/returns between these investment vehicles (bond fund vs dividend stock fund)? So long as my father in law isn't counting on the fund to increase in value and doesn't plan to sell his shares (they would be left for his kids), are they basically the same thing? I'm far too novice to understand the differences or know which of the two may be best for his situation.
Would anyone be able to offer advice please?
Thanx
Last edited by hoangtrunglien on Sat Jul 08, 2017 8:18 am, edited 1 time in total.
mhalley
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Re: Bond funds vs. Dividend Funds?

Post by mhalley »

Stock funds and bond funds are wildly different in terms of risk. A stock fund could potentially drop 50% in a major crash. Bogleheads are not into dividends, in general a total return strategy is thought to be superior. Vanguard wrote a white paper on the subject that might be helpful.
https://personal.vanguard.com/pdf/s352.pdf
The current low-yield environment is leading many investors to focus on only one piece of their portfolio’s total return, namely, the income return. This focus may be encouraging investors to consider strategies such as extending the duration of their bond portfolios, tilting their bond holdings toward high-yield bonds, or shifting their equity holdings toward higher-dividend-paying stocks. Investors may adopt one or more of these strategies in the belief that they will be rewarded with a more certain return and, therefore, less risk. What these investors may fail to realize is that moving away from a broadly diversified portfolio and concentrating on certain sectors can potentially result in a less diversified portfolio, increased risk, decreased tax-efficiency
(for taxable investors), and/or an increased chance of falling short of long-term financial goals. On the other hand, as discussed in this paper, a total-return approach potentially offers a number of portfolio benefits, including maintaining diversification, enhancing the portfolio’s tax-efficiency, and increasing the portfolio’s longevity.
Individual bonds are more risky than bond funds, having a bond fund is certainly reasonable and easier than maintaining a bond ladder. Check the wiki on bonds vs bond funds.
https://www.bogleheads.org/wiki/Individ ... _bond_fund
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retiredjg
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Re: Bond funds vs. Dividend Funds?

Post by retiredjg »

I would not look for dividends although having some is fine. When investing for dividends, people tend to get too concentrated in a certain kind of stock or have too much in bonds.

Like the above poster, I recommend a total return approach - spend the dividends and also sell some of the stock or bond shares as part of the total return.

If your father needs about 4%, I suggest just setting up a portfolio that is at least 40% stocks and taking the 4% (this includes taxes). The next year take that same amount (the 4%) and add on whatever inflation is. In the past this has lasted a minimum of 30 years with a very high success rate, even through market crashes, etc.
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nedsaid
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Re: Bond funds vs. Dividend Funds?

Post by nedsaid »

How old is your father in law? A possible answer would be for him to buy a Single Premium Immediate Annuity with a portion of his nest egg. My guess is that the effective withdrawal rate from the annuity would be close to 7%, sustainable withdrawals from a nest egg according to academic research is more like 3.5% to 4.0%. Of course, if he does a joint annuity with survivorship, the effective withdrawal rate would be less. This would take pressure off the remaining nest egg. This option would depend upon such things as age and health.

There is a lot of appeal to an inflation adjusted income stream from dividends. We know that dividends can be cut but also that companies do this as a last resort. This is one reason I haven't sold off my individual stocks. Something about seeing those dividends hit my account! If you go this route, you need to pay attention to such things as payout ratio. How much of earnings are being paid out in dividends?

A problem with older investors is that it gets to be yield at any cost. The higher yielding investments like High Yield Bonds, Preferred Stocks, Master Limited Partnerships often tend to be self-liquidating investments. You get the great yield but the principal often keeps dropping. A portion of the fat yield is well disguised return of principal. It is sort of like a dog chasing his tail.

My advice has been to look at the market yields. The yields of US Total Stock Market Index and US Total Bond Index are a good place to start. You don't want to reach for yields that are much higher than the market averages. Very high yields for a stock can indicate that the company is experiencing problems and that the dividend might get cut! Much higher than market yields on a bond can indicate credit problems, in other words the bond might default.

Your father in law might be better off with a total return approach where he harvests capital gains in addition to dividends and interest. More money has been lost chasing yield than at the point of a gun.
A fool and his money are good for business.
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saltycaper
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Re: Bond funds vs. Dividend Funds?

Post by saltycaper »

hoangtrunglien wrote:
His goal is to have something which produces income annually and he doesn't much care about the unrealized gains or losses on his initial investment.
No matter the investment, the gain or loss matters. Before considering the stock and bond allocation, the first step would be to shift fundamentally the way he views investment performance. This can be hard, as one has to admit that the previous way they viewed their investments is irrational. (If I lose a ton of money, I will simply pretend I didn't.)
hoangtrunglien wrote:
Would anyone be able to explain the different risks/returns between these investment vehicles (bond fund vs dividend stock fund)? So long as my father in law isn't counting on the fund to increase in value and doesn't plan to sell his shares (they would be left for his kids), are they basically the same thing?
This is one of the problems of looking just at income and not total return. The risk profile of stocks and bonds appears closer if you look just at income rather than if you look at total return. The value of stocks might fall 50% and the dividends might be cut 25%. So which risk are you taking? Well, both of them. Just because you ignore the 50% loss doesn't mean it isn't a risk you are taking. As is mentioned in the paper cited above, focusing on income can produce an asset allocation inappropriate for one's risk tolerance.
Quod vitae sectabor iter?
Avo
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Re: Bond funds vs. Dividend Funds?

Post by Avo »

I'd give him a copy of the bogleheads guide, and then leave it alone.

Investing for income (and ignoring principal fluctuations) is a very popular meme. He should not make any changes until he's completely comfortable with the new (to him) investing paradigm.
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