I am a begrudging buyer of bonds and fixed income. Yes, I need them for asset allocation and diversification but I really dislike buying them for several reasons: (i) their payments are tax inefficient; (ii) their face value is affected, relatively speaking, to macro-economic factors more than stock; (iii) with a long investing horizon (20+ years), you can get better return from stocks; and (iv) unless they are government issued bonds, there is no guarantee of payment- see ABCP (the term fixed income is a bit of a misnomer).  But, alas, they are like carrots to me. I don’t like them but I make them part of my diet.

Outside my retirement account, I am building a dividend fund- a fund that pays lots and lots of dividend (one hopes) and I have debated the relative merits of even buying any fixed income instruments in this fund. Thus far, I have decided to forgo such instruments (by way of background, I do have an emergency fund in a high-interest account which is yielding GIC like rates) and I have been playing with the concept of anchoring this dividend fund with slow growth/high yield dividend stocks that returns to me fixed income like returns as a way to mitigate against any downside risk.

I better explain. There’s many ways of dividing up the dividend stock world- by industry, geography etc. I like dividing it up into fast growth and slow growth. Fast growth dividend stocks are stocks that are both increasing their dividends and their stock price. They tend to be members of the dividend aristocrats (well-managed businesses that have increased their dividend for the last 7 years straight) and in growth industries such as banks, insurance companies and real estate companies (remember this is a historical list and do not take recent history to be indicative of historical trends). Here’s a quick and dirty on finding members of the dividend aristocrats. Their dividend yields tend to be in the 2-4% range because their share prices keep appreciating.

These stocks, because they are both growth and income oriented, tend to appreciate in good times but, conversely, drop in bad times (financial stocks tend to both lead the down-turn and the recovery). The second issue is that if these stocks raised their dividends too much in good times, they are exposed to a dividend cuts or halts in a downturn. A prime example is Citigroup who rode the housing and private equity boom up but got caught when they both crashed, leading to a battered stock price and a dividend cut. Thus, you end up with the worse of both worlds- falling stock prices and less dividends in your pocket.

If you hate bonds, my pet theory is to mitigate the risk of fast growth dividend stocks with slow-growth stocks. I would define slow-growth stocks  as mature industries- think tobacco, booze, utilities- where the technological advances have peaked or pricing is strictly regulated (utilities) and profit margins are predictable and stable. As such, there’s a lot of cash lying around which is repaid in the form of dividends and, given the maturity of the business, the share prices tends to appreciate slowly given that growth is not assured.

Thus, with money being returned to shareholders and a relatively steady stock price, the dividend yields tend to be higher (4% plus; for example, Rothmans’ dividend yield is 5.4%) and, given that the stock price generally appreciate gradually, your return has a very bond-like quality to it. They are safety stocks. The stocks you buy in bad times. For example, every broker seems to be recommending the utility company Fortis right now- earning estimates are modest (8.6%) but it pays steady dividends and both the upside potential and downside risk is modest (to be clear, you can be a slow growth dividend stock and a member of the dividend aristocrats)- this is not a recommendation, do your own due diligence. One warning- a stock with high dividend yield is not necessarily a slow growth stock. A recent spike in its dividend yield may indicate its a growth stock in trouble (see Bank of America).

The key is not to stack your portfolio with too much slow growth stock if you have a long investing horizon. You would allocate a slow growth stock like you would allocate fixed income- the older you are, the more slow growth dividend stock you have. I am playing with the idea of 20% of my dividend fund being in slow growth stock. Now, this concept is not for everybody. It depends on your risk tolerance (and remember I have an emergency fund to back-stop a 100% equity fund and I am a good little asset allocator in my retirement fund which is much larger than my dividend fund) so context is everything.

Perhaps it is a semantics argument and slow growth/fast growth stocks is really another way of equity diversification among industries but something to think about when you look at dividend stocks. Its not all always about yield. There may actually be ways to reduce your down-side risk if you are putting together a dividend fund.