How to Replace Bonds With Dividends

by Leslie McClintock

While both interest payments and dividends from stocks are popular forms of investment income, dividends have two advantages over bond interest payments: Dividend payments from qualified U.S. companies receive a favorable tax rate compared to interest payments. Dividends also have one key attribute that bond interest generally lacks: The potential for growth. However, dividend payments are not guaranteed.

Sell some or all your bond holdings. Bear in mind that unless you hold these assets in a tax-favored account, you will have to pay capital gains taxes on any profits you make on the sale. To cushion the blow, you could sell some positions in which you lost money during the same tax year. The losses cancel out your capital gains, dollar-for-dollar, lowering your tax bill.

Consider preferred stocks. These are a kind of hybrid between stocks and bonds. Preferred stocks pay a regular dividend, but on a non-guaranteed basis. If a company skipped a bond interest payment, it would likely be forced into bankruptcy. A company has no obligation to pay a dividend to preferred stockholders. However, the company may not issue a dividend to common stock holders unless it pays the full dividend due to preferred shareholders. Some company bylaws guarantee that the company will also pay dividend payments to preferred stock shareholders in arrears, prior to issuing a dividend to common stock shareholders. Preferred stocks can be effective income-generating investments. Share prices tend to fluctuate with prevailing interest rates. When interest rates rise, preferred share prices fall, and vice versa.

Purchase dividend-paying stocks. Some companies have long and steady history of consistent or increasing dividends. Absent a history, you may consider investing in a company that has reliable earnings from year to year, or sufficient cash reserves to continue to pay dividends even in lean periods. You can identify them with the help of a broker or financial adviser, by reading and analyzing their annual reports and financials yourself, or by using a stock screening service such as Morningstar.

Consider growth and income mutual funds. These funds will typically have the words "growth and income" in the fund name, or listed as a fund objective in the prospectus. These mutual funds will seek to invest in dividend-paying stocks with some growth potential. Mutual funds may be appropriate if you cannot diversify into very many stocks given the amount of money available, or if you do not want to do the research on stocks yourself, and are willing to pay a portfolio manager between 0.2 and 2 percentage points per year to do it for you.