Updated Wednesday, April 16, 2014 as of 3:20 AM ET
Portfolio - Fixed Income
Can Bond Funds Yield Strong Dividends?
by: Tom Steinert-Threlkeld
Tuesday, October 16, 2012
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In the past three years, bond funds have been raking in the assets.

In August 2009, they had captured $1.7 trillion in investor capital. By the end of September , they had $3.0 trillion, according to Morningstar.

Funds that invest in stocks have taken it on the chin, almost without relent. This year, $59.0 billion has been pulled out of stock funds. Since the start of 2007, more than half a trillion dollars has been pulled from domestic stock funds, including roughly $26 billion in September, according to the Investment Company Institute.

But should it be so? Probably not.

"What you have is a fairly unusual disconnect between returns and flows,'' says Morningstar mutual fund research director Russ Kinnel. "Historically, you can look at the past year or two of returns and that is going to tell you where the flows are going to go.''

Not so with stock funds.

The most direct twin to funds that invest in interest-bearing bonds are funds that invest in dividend-paying stocks.

In 2009, bond funds produced an average return of 16.7%, according to Morningstar. Dividend-paying stocks? An average of 25.3%.

Bond funds have not come close, since. In 2010, the average bond fund return was 5.9%. In 2011, 6.4%. This year, so far, 6.5%.

Fund clients would have been much better served if they were pushed into funds that focused on dividend-paying stocks.

Funds that invested in dividend payors had an average return of 25.2% in 2009. In 2010, 14.7%. The 2011 year was the only clunker at 1.9%. This year? Up 11.95% so far.

Bond funds should be so generous.

But dividends may not be the key to the success of funds that invest in dividend-paying stocks.

In fact, the numbers indicate that stocks that appreciate do just as well as dividend-paying stocks.

To that end, Kinnel notes that the returns on funds that invest in dividend-paying stocks pretty closely mirror the returns generated by straight investment in the Standard & Poor's 500.

That broad measure of the productivity of stocks gained 26.5% in 2009, 15.1% in 2010 and just 2.1% in 2011. Funds that invested in dividend-paying stocks? Just about the same.

Which should lead rational investors to stock funds of all kinds, whether they pay dividends or not, ahead of bond funds.

But Kinnel said psyches are too damaged to achieve that sort of rationality, right now.

Investors are inundated by around-the-clock news, he says, hammering on the U.S. deficit or the pending doom in major European countries from their debts and such gloom has its impact.

"They're paying more attention to that than the statements they are getting from their brokerage," Kinnel said.

Also leading to the preference for bond funds, even in a near-zero interest-rate world, are the "scars from '08.'' Many investors saw their financial holdings lose a third or more of their value, when the global credit crisis erupted.

That has created an environment where investors have looked for safety in anything that pays a guaranteed return.

The world's largest bond fund is the Total Return Fund, from Pacific Investment Management Company. Run by PIMCO co-founder Bill Gross, that fund has more than a quarter-trillion in assets.

But Kinnel argues that another Gross-run fund, Harbor Bond Fund Institutional Shares (HABDX), invests in bonds that are better-priced and warrants closer attention.

He also is high on the Loomis Sayles Bond Fund (LBFAX), run by Kathleen Gaffney and Dan Fuss, which will invest in a wide range of fixed-income securities, from high-yield bonds to foreign debt.

But funds that invest in dividend-paying stocks still, numerically, seem to have the upper hand.

Vanguard, for instance, has an equity income fund that generated a return of 10.6% in that off-year when stock funds only put out 2%, as a whole.

Vanguard also has a dividend growth fund that Kinnel finds worth noting, even though its returns pretty much match those of the S&P 500.

One factor favoring investing in Vanguard funds, he notes, is their focus on reducing cost of operations.

That's because, all other results being equal, saving 100 basis points per share on fund expenses is ... 100 basis points in the bank.

With zero increase in risk.

But advisors should not let mutual fund clients ever get caught up in the "magic" of dividends, as opposed to the interest payments of fixed-income products held by a bond fund.

Or the magic of any category of fund.

"I don't think there's a free lunch where you can simply buy any large group of funds and expect them to outperform the S&P 500 every year,'' he said. "If they did then we'd all be in them and then they'd really underperform."

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