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Dividend Stocks Instead of Bonds

The markets of coming years may resemble what prevailed after World War II, according to Malkeil. Seeking to avoid another Depression, the government held down interest rates in the late 1940s, and yields on 10-year Treasuries were below 2%. Then as the economy gained a steady footing, the government unleashed rates. "When interest rates were allowed to rise in the 1950s, bond holders got killed," says Malkiel.

According to Ibbotson Associates, long-term government funds lost money in the 1950s. During the 1960s and 1970, bonds delivered meager results that were less than the inflation rate. So after considering taxes and inflation, bond portfolios shrank for more than three decades. Meanwhile, stocks delivered decent after-inflation results.

To illustrate why dividend stocks are relatively attractive now, Malkiel notes that shares of AT&T (T) yield 5%, while the company's 10-year bonds yield only 2.5%. The low bond yield is not enough to compensate for the risks of rising rates and an inflation rate that is currently running at 2%. "With the stock, you get a reasonable dividend yield, and a chance for some growth," he says. "Under the best circumstances, the bonds will give you a zero real rate of return."

Advocates of government bonds dispute Malkiel's reasoning and caution investors against shifting outsized stakes to dividend ETFs. The ETFs can come with risks that investors don't appreciate, says Don Bennyhoff, a Vanguard senior investment analyst. The funds often have big stakes in a few sectors.

Before the market turmoil of 2008, many dividend funds had outsized holdings in financials because banks and insurers paid hefty dividends. The financial stocks collapsed as the credit crisis unfolded. These days many dividend funds have overweights in consumer staples.

Bennyhoff concedes that bonds could lag stocks in coming years. But he argues that fixed-income holdings can help to cushion portfolios. He says that on the recent day when the Cyprus Parliament rejected a bailout, U.S. stocks sank, but bonds held firm. "Bonds can help to temper the volatility of your portfolio," he says.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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