Yellowstone Financial, Inc.

Are high dividend funds the income answer?

It’s no secret that retirees and others looking for investment income have suffered in our low interest rate environment.  The standards of fixed income investors – Treasury bonds, CDs, online banks, and municipal and corporate bonds – are not providing enough income for retirees to support themselves.

The search for income has now led to dividend mutual funds. Many of these funds such as Vanguard’s Equity Income Fund (VEIPX) and High Dividend Yield Index Fund (VHDYX) have dividend yields that exceed 3 percent a year.

This seems very attractive at first glance.  Rather than purchasing a Treasury bond and paying ordinary income tax on the interest, you are able to secure a higher yield with dividend mutual fund.  The income is mostly subject to a 15 percent federal tax rate (at least through the end of this year).  Plus you get the appreciation of an equity investor, while Treasury bonds will only pay back their principal.

But should retirees that would normally load up on staid bond funds replace them with high yield equity funds?  Let’s consider the case.

There’s no doubt that the fixed income standbys earn little interest.  Ten year Treasury notes pay 1.75 percent.  You can approach 3 percent with a ten year brokered CD, but they are hard to find and lock you into today’s low rates.  Investment grade corporate bonds (with greater principal risk) pay close to 4 percent at the same maturity.

Dividend mutual funds purchase the stocks of companies that pay relatively high yields to their investors.  If you purchase a dividend fund, you’ll be holding a small part of companies such as Exxon Mobil, Chevron, and JP Morgan Chase.  Rather than reinvesting all profits in their business, they offer a quarterly dividend to entice shareholders.

Dividends can provide a stream of income from your portfolio without having to liquidate holdings.  The idea of having 3 percent of your investment come back to you without “eating into your principal” is compelling.  Once you consider taxes, it looks even better.

Unfortunately the whole case for holding dividend funds in lieu of interest earning alternatives rests on a logical fallacy.  One of the most important roles of interest earning investments is that they tend to perform well during market downturns.  Most bonds did well even in 2008 when we were busy bailing out banks that were too big to fail.  The US Aggregate Bond Index increased 5.2 percent in 2008.  Meanwhile the S&P 500 total return was down 37 percent.

Dividend funds did not fight the trend that year.  Vanguard Equity Income fund was down 31 percent in 2008, while its High Dividend Yield Fund was down over 32 percent.    Imagine yourself in 2008 with a dividend fund.  You purchased it for income, but lost close to a third of its value.  If you panicked during this time, the dividend fund would not have allayed this fear.

If you’re looking for a secure stream of income that provides predictable returns even in the midst of market downturns, dividend funds won’t help you.  While they generate more income than most equities, they do not achieve the vital purpose as a safe haven while the market is in decline.

As much as it hurts to accept low interest income, your best bet is to purchase high quality, relatively short-term fixed income investments for safety.  When interest rates do increase, you’ll be in a good position to move up to a higher rate.   More importantly, you’ll be less prone to panic and sell low like other individual investors when the markets bleed red.