Why You Should Buy Stocks That Pay Dividends

They can help you get set for rising interest rates.

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Since the financial crisis took a huge toll on their portfolios, investors en masse have taken refuge in bonds. From the beginning of 2009 through the end of this past September, they pulled a total of $38 billion out of stock funds, according to the Investment Company Institute. Meanwhile, they poured $618 billion into bond funds. "Investors' tolerance for risk seems to be lower than it has been for quite a while," says Brian Reid, chief economist for ICI. Little wonder. After years of climbing at an average yearly clip of more than 18 percent, the S&P 500 index is in the red for the past decade.

But with yields low and prices high, it's time to rethink bonds as your safe bet, experts say. The Federal Reserve has kept the target range for the federal funds rate between zero and 0.25 percent since December 2008 in hopes that low rates will help jump-start the economy. A rate hike isn't expected to come until the second half of 2011 at the earliest. But "rates are going to have to go up at some point," says Brian Gendreau, market strategist with Financial Network. When that happens, the price of the bonds will go down. Even people invested in supersafe treasuries will find themselves losing money unless they own individual bonds and hold them to maturity.

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No one can time the Fed's decision, but one move you might make in preparation is to shift part of your bond portfolio into dividend-paying stocks. While stocks are inherently riskier than bonds, these shares are generally less volatile than other types of stocks and in many cases offer income-hungry investors attractive yields relative to bonds. They tend to do well in a rising rate environment, which is usually a sign that the economy is picking up. When the economic picture improves, companies generally raise their dividend payouts slowly over time, says Howard Silverblatt, senior index analyst at Standard & Poor's. "Overall, you're looking at a positive scenario." The number of companies raising their dividend was up 57 percent during the third quarter over the same period last year, according to S&P.

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Two funds with a strict dividend mandate and good performance records are Vanguard Dividend Growth (symbol VGIDX) and Vanguard Dividend Appreciation ETF (VIG). The former focuses on strong, steadily growing companies with a long history of boosting dividend payouts year after year. The latter is an exchange-traded fund tracking an index of companies that have increased their annual dividends for at least the past 10 years. It holds about 140 stocks of well-established companies in various sectors such as Coca-Cola, McDonald's, and Chevron. Year-to-date, the funds are up 7 percent and 10 percent, respectively.

Meanwhile, back in your bond portfolio, it's best not to reach for higher yield by buying treasuries with longer maturities. Those securities may look most appealing now, but they'll be hit harder when rates move upward. It's important to be diversified among a range of fixed-income assets and maturities, says John Diehl, senior vice president in the retirement division of The Hartford. Two bond fund favorites of Alice Lowenstein, director of managed portfolios at investment research firm Litman/Gregory, are PIMCO Total Return (PTTAX) as a core holding and Loomis Sayles Bond (LSBDX) as a supporting player.

[See 7 Great Dividend Funds.]

PIMCO's manager Bill Gross generally sticks to offerings in the Barclays Capital U.S. Aggregate Bond Index (the most commonly cited bond index), though he will occasionally invest in other sectors like high-yield bonds or emerging-markets debt. Loomis Sayles Bond is a multisector bond fund that, at the end of September, had no exposure to U.S. government debt. The funds are up an average annual 7 percent and 10 percent, respectively, over the last 10 years. Tom Lydon, editor of ETFTrends.com, suggests the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which covers the medium-term investment-grade corporate bond universe. It has returned 10 percent so far this year.