The most significant driver of the financial markets over the past seven years has been the relentless effort of the Federal Reserve and other global central banks to push down interest rates. These near-zero short-term rates have had profound ramifications. Prices on other assets (such as stocks) have risen as investors have moved out of traditional safe havens into more risky investments as they search for better returns.

While the Federal Reserve appears poised to finally allow short-term rates to begin an ascent from their current near-zero level, there is no indication that other central banks globally are ready to follow suit. This will limit the Fed’s ability to raise rates in the U.S., and likely means that historically low interest rates will be with us for some time.

Retirees have arguably been the group hardest hit by this extended near-zero interest-rate policy. Traditional savings products (e.g., money-market funds and bank CDs) yield very little, eliminating one traditional safe haven. Bonds performed well initially as interest rates declined (bond prices rise as yields fall), but with rates now at rock-bottom levels and poised to rise, bond prospects going forward are very much in question.

In their search for alternative sources of current income, some retirees have turned to dividend-paying stocks. This has worked out quite well over the past several years, as stocks have risen consistently and dramatically since the spring of 2009.

The current yield landscape

It’s easy to understand the appeal of exchanging bonds for dividend-paying stocks when the recent statistics of both are considered. As the nearby table shows, as of November 10, the Vanguard Intermediate-Term Bond Fund was yielding 2.7%, but its total year-to-date return for 2015 (including that yield) was only 0.9%. In contrast, the Vanguard High Dividend Yield ETF was yielding 3.1%, with a year-to-date total gain of 1.0%. (In both cases, the total return is less than the current yield, indicating that the value of the stocks and bonds in the portfolios has declined this year, offsetting some of the income earned.)

With the dividend-oriented ETF boasting a higher yield and higher year-to-date returns than the bond fund, it’s understandable why one might consider switching some bond money into dividend-paying stocks. But there’s more to this story than just yield and return — there’s also the matter of risk.

Dividend stocks are still stocks

Nothing drives home the point of the relative risks of stocks vs. bonds than looking at what happens to their total returns during a sharp downturn. Note the ‘2008 Return’ column of the table: all of the dividend-focused funds and ETFs experienced losses of 22%-36%. Many dividend funds and ETFs did even worse (we only included funds that lost less than the S&P 500 index in 2008). In other words, you’re seeing the best of the dividend group in that table because those with even larger 2008 losses have already been screened out!

In contrast, there is one number in that column that stands out sharply from all the others: the lone bond fund’s gain of 3.9%. That’s right, when these dividend stock funds were losing a third or more of their value during the last bear market, bonds not only didn’t lose ground, they actually earned positive returns. In fact, looking back over the past 20 years, the very worst 12-month loss experienced by the Vanguard Intermediate-Term Bond Index Fund was a mere -4.15%.

As an investor, it’s important to keep one eye firmly fixed on risk at all times. But that becomes even more important than usual when the stock market has enjoyed a largely uninterrupted rise for nearly seven years. The fact that this is one of the older bull markets in history shouldn’t necessarily cause someone to pull back from their normal stock allocation, but it should definitely cause some rethinking about the idea of taking money from a bond allocation to put into stocks. Make no mistake, whenever the next bear market arrives, dividend-oriented funds will almost certainly suffer significantly greater losses than bond funds. In terms of short-term downside risk, there’s simply no comparison between stocks and bonds.

Options among dividend funds

So, to be perfectly clear, SMI does not think it’s a good idea for readers to be taking money from their bond allocations to invest in dividend-paying stocks or funds at this point in the market cycle. That said, there may be readers who understand the risks, but want to identify the better dividend-paying funds and ETFs in order to build a portfolio that will produce a certain amount of current income.

For these readers, here’s a brief overview of how to navigate the dividend-focused fund/ETF landscape.

Dividend funds and ETFs can be fairly easily divided into two groups. One emphasizes current high yield, and isn’t as focused on how long that high dividend payout can be sustained. The other focuses on buying the companies that are growing their dividends (or are the least likely to have to cut or suspend their dividend during an economic downturn), even if that means the current yields are lower. This is why when you look at dividend funds/ETFs, you’ll sometimes see some with yields as high as 4% or more with others less than half that.

While it’s tempting to reach for the higher current yields of the first group, it’s important to recognize that the latter group is a significantly safer option. These “growers,” which are often easily identified by their use of “dividend growth” or “dividend appreciation” in their names, typically are much more resilient in down markets. Their focus on companies with the strength and financial wherewithal to withstand negative events and bad market conditions gives them a bit of a cushion. Many of these funds use screens to include only companies that have maintained or grown their dividends every quarter for the past 10 years, which keeps weak companies out of the portfolio. Focusing on these dividend-growth/appreciation type funds takes at least a partial step toward mitigating the higher risks inherent with these being stock investments.

The table above is a good starting point in identifying strong dividend funds and ETFs, though it’s hardly an exhaustive list. The most important thing to understand is the tradeoff between yield and risk. If you find a fund/ETF with a particularly high yield, you can be confident it will be more vulnerable to losses should the stock market turn lower.

The pair of Vanguard dividend funds in the table illustrate this well. While neither is an extreme example of their respective groups, Vanguard High Dividend Yield sports a much higher yield than Vanguard Dividend Appreciation (3.1% vs. 2.3%). On the risk side, however, we can see that High Dividend Yield lost 32.1% in 2008, whereas Dividend Appreciation’s loss was milder at 26.6%. This is the sort of tradeoff you typically see on the yield/risk spectrum with these dividend-oriented funds, so be wary of funds with too-good-to-be-true yields — they likely come with higher risk.

Conclusion

Dividend-paying stocks can be a helpful tool in creating a portfolio that generates current income. But investors should understand the dramatic step up in risk if they are substituting stocks for bonds in pursuit of that income. “Dividend growth” funds that focus on the high-quality payers won’t necessarily pay the highest yields, but compensate with better performance during market downturns. But even the best of this group are going to be significantly more risky than most bond funds.

While we will occasionally recommend a dividend-oriented fund in Upgrading when the momentum rankings call for it, we don’t otherwise see a particularly useful role for them within the SMI philosophy. But they can certainly be used outside the normal SMI framework by individuals with specific current income needs, as long as these cautions and tradeoffs are understood.