Dividend-paying stocks are the cornerstone of any successful income investing strategy. But a diversified portfolio is the key to long-term success. Although bond yields continue to plumb near-record lows, every investor should have some exposure to fixed-income securities.
When Standard & Poor's made noises about cutting the US government's credit rating, many analysts opined that such a move would cause a spike in interest rates.
But when the rating agency finally downgraded the world's largest economy's credit rating to AA+ from AAA, investors shifted money into Treasury securities and other high-quality bonds.
What prompted this counterintuitive move? High-quality bonds still offer the best insurance against a weakening global economy.
Dividend-paying stocks are by far the best way for income investors to beat inflation and credit risk while building wealth and generating income. But, as I mentioned in Dividend Investing: Top Six Takeaways After a Volatile Week , equities lose value when investors worry about economic weakness. In contrast, bonds gain ground during the bad times, providing your portfolio with a bit of ballast.
For our advisory services website, Personal Finance , we hold four open-end bond funds in the Income Portfolio: Northeast Investors Trust (NTHEX, 800-225-6704), Vanguard GNMA (VFIIX, 800-997-2798), Vanguard Intermediate-Term Investment-Grade (VFICX) and Vanguard Intermediate-Term Tax-Exempt (VWITX).
The three Vanguard funds hold only high-quality debt of limited duration, which limits exposure to fluctuations in interest rates. Northeast Investors Trust has a long track record of picking up bargains in the universe of junk bonds. All four funds offer higher yields and less risk than their peers, thanks to their low operating costs and expense ratios. Bond funds that charge higher fees often take on additional risk in an effort to boost yields and appeal to investors.
Vanguard GNMA has 99 percent of its portfolio in AAA-rated, government-backed debt, and its holdings sport an average duration of less than 4.4 years. Issues rated BBB+ or better account for more than 95 percent of Vanguard Intermediate-Term Investment Grade's portfolio, while the average duration is only 5 years. Vanguard Intermediate-Term Tax-Exempt allocates more than 99 percent of its investable assets to bonds rated BBB or better and offers an average duration of 5.6 years.
Even in their worst years, our Vanguard holdings did little worse than break even. Northeast Investors Trust dropped precipitously in 2008 but has rebounded significantly as corporate credit markets normalized.
That's pretty strong assurance these funds will hold their own going forward, even if the economy should sink into recession. And if interest rates should head higher, their low duration will limit downside. For more on defending your portfolio against rising interest rates, see Jim Fink's InvestingDaily.com article, Short-Term Bond Funds Add Ballast in Rough Investment Waters .
Putting all your money in bonds is a loser's game: The potential for price appreciation is minimal, and yields are at the lowest levels in decades for all but the highest-risk fare.
But as part of a diversified portfolio, our high-quality bond funds provide valuable balance and a reliable source of income if our equity picks take a temporary hit.