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So can anyone tell me exactly why it would be better to invest in a bond fund than in high dividend stocks like NLY

Asking why a bond fund is better than NLY is like asking why Oklahoma is better than Missouri. Neither is better or worse- they're different.

First, NLY is an individual security. I'd hold funds instead of securities for diversification purposes.

Second, NLY is a mortgage REIT. It's a good idea to have a small (~7%) portion of your portfolio in REITs, of which a small portion might be mortgage REITS (most REITs own real estate, not securities).

You can own anywhere from 0%-100% of your portfolio in bonds (and other fixed income investments), depending on your time horizon, risk tolerance, etc.

Neither is safe from erosion of the initial investment

No investment is totally safe from erosion of the initial investment in real terms. (even your TIPS will erode if the CPI number isn't accurate). Owning a bond fund is just like owning a bond/CD ladder. The "NAV" (current value) of your ladder will fluctuate, but if you wait until each bond matures this doesn't affect you. Same with a bond fund, except in extreme circumstances.

and NLY has much better dividends

If you ever wonder why one investment offers a higher return than another, the answer is usually risk. NLY is a high risk, highly leveraged investment. These guys can return you that juicy spread between short and long term rates as long as short term rates stay low, but what happens if they rise a couple of points? I'm not a mortgage REIT expert but I'd guess that div could be wiped out pretty easily. And then what would happen to the share price?

In short, there's no free lunch, which is why you should diversify.


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