On Substituting Dividend-Paying Stocks For Bonds In The Current Environment

Today's article is going to come from a very interesting place for ETF Monkey.

Readers who have followed my work will by now be familiar with its main focus, namely using ETFs to build low-cost, extremely diversified portfolios. An example of this is the ETF Monkey Vanguard Core Portfolio; based on just three ETFs yet offering well-balanced exposure to both domestic and foreign stocks as well as bonds. In the article linked above, I advocated establishing target weightings and sticking to these. I wish to reiterate that, for many investors, I would recommend sticking to that game plan.

ETFs form the core of my portfolio, comprising 81.11% of my total portfolio as of this writing, and I am very conscious of maintaining and rebalancing to target weights.

However, I occasionally make an exception and maintain modest positions in individual stocks for specific reasons. As of this writing, two such positions are AT&T Inc. and Verizon Communications, each of which holds a weighting of roughly 2.5% in my portfolio. I have actually held both stocks for a over a year but recently added to each position to bring it up to the weighting I mention.

This article will talk about why I did so and, in the process, hopefully offer those who may be a little more adventurous something to think about.

Bonds vs. Dividend-Paying Stocks in the Current Environment

One of my core holdings is the Vanguard Total Bond Market ETF. For more about this ETF, feel free to check out this article. To reiterate, this ETF is still a core holding for me, nothing has changed about that. However, the specific set of market circumstances in which we find ourselves today started me thinking along the lines of what I will share next.

Here are a couple of salient data points around BND. Feel free to check out my data from the fact sheet if you wish.

1. On the 'Overview' tab, we can see that the current SEC Yield is 2.20%.
2. On the 'Portfolio & Management' tab, we find that the duration of the ETF is 5.7 years.

In the article I link at the outset of this section, I explain the concept of duration as it applies to a bond ETF. I will summarize ever so briefly here. The theory is that, should interest rates rise 1%, the value of BND should decrease somewhere in the neighborhood of 5.7%. Given the fact that interest rates are expected to rise at some point, though exactly when is certainly unclear, this becomes a matter of some concern.

In contrast, at today's prices, both AT&T and Verizon are paying dividends in excess of 5%, close to 6% in the case of AT&T. Over the past year, both have declined further than the S&P 500 in price. Further, as I write this article, we are hovering just above the official correction level on the S&P 500 and the NASDAQ and are in correction territory on the Dow. In other words, at least some of the air has been let out of what was an overpriced market.

That led me to ponder a couple of interesting questions:

1. What is the level of risk that AT&T and Verizon could drop an additional 5.7% in price, as BND should do if rates were to rise 1%?
2. How does that risk measure up with a current dividend in excess of 5% as opposed to the 2.2% I am receiving from BND?

As far as the prospects for AT&T and Verizon going forward, I would recommend readers search those ticker symbols on Seeking Alpha and read some of the recent, high quality articles that have been written on these companies.

The bottom line? I recently used some cash that my weighting targets would have dictated go to bonds to increase my weighting in AT&T and Verizon instead.

Perhaps you would not want to copy me exactly, since there is some level of sector risk in that both of these are telecommunications companies. However, if the basic idea appeals to you, here are a couple of potential variations you might consider.

Idea #1: A Triumvirate of Individual Stocks

For our first variation on the theme, I started to think about picking a basket of three securities that met the following criteria:

1. They must offer a solid history of dividend performance.
2. They must have underperformed the market over the past year.
3. They must be from three different sectors, for diversification.

Below, I present three stocks that meet those criteria: Johnson & Johnson, AT&T Inc., and Wal-Mart Stores, Inc..

Let's start by looking at their performance over the past year, compared to the S&P 500 (you can click on any picture in this article to enlarge it).

JNJ, T, WMT: 1-Year Performance vs. S&P 500

Clearly, for one reason or another, all three have underperformed the S&P 500 over the past year. Of course, anything can happen. However, this would appear to minimize the risk of the group, taken together, experiencing a further decline of more than 5.7% in price.

They come from three different sectors, yet all fulfilling basic needs. There is nothing esoteric about any of them.

As far as dividends, as of their respective closing prices on 9/24/15, AT&T is paying a dividend of 5.85%, Johnson and Johnson 3.24% and Wal-Mart 3.07%. If you were to purchase equal dollar amounts of all three, you would end up with roughly a 4% dividend.

Lastly, both Johnson and Johnson and Wal-Mart meet the current criteria for inclusion in the Vanguard Dividend Appreciation ETF and all three meet the criteria for inclusion in the Vanguard High Dividend Yield Fund.

Idea #2: A Top-Quality ETF to Accomplish the Same Goal

For our second variation, we will actually use the second of the ETFs mentioned at the conclusion of the last section, the Vanguard High Dividend Yield Fund.

Similar to the three stocks featured, this ETF has also underperformed the S&P 500 over the past year, as shown here.

VYM: 1-Year Performance vs. S&P 500

The fund carries a rock-bottom expense ratio of .10%. As of this writing, it carries an SEC Yield of 3.43%, a little lower than the combined 4% of the three stocks I suggest above but still substantially higher than BND's 2.20%.

This next picture captures several details around the fund's composition.

Vanguard VYM - Portfolio Composition

Summary and Conclusion

As mentioned in the outset, this article represents a slight departure from my normal work as ETF Monkey. We discussed stocks as opposed to ETFs, at least in part. We also discussed the perhaps more radical idea of at least temporarily substituting dividend-paying stocks for some portion of our traditional bond weighting, given the present environment.

Whether or not you agree with me, I hope you have found this article stimulating and worth reading. As always, I welcome your comments.

Happy investing!

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Disclosure: I am not a registered investment advisor or broker/dealer. Readers are cautioned that the material contained herein should be used solely for informational purposes, and are encouraged to consult with their financial and/or tax advisor respecting the applicability of this information to their personal circumstances. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.