Get income from dividend-focused ETFs

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Multi-asset investing - May 2015

The yield suppression in Europe’s government and investment-grade bond markets is reaching unprecedented levels.

Following the aftermath of the 2008 credit crisis and its relentless rally since the ‘whatever it takes’ speech by European Central Bank (ECB) president Mario Draghi in 2012, German two-year Bunds were among Europe’s first sovereigns to record zero and below-zero bond yields. That was in the summer of 2012.

Since then the occurrence of negative bond yields have spread beyond the safest of safe-haven assets to now include longer-dated maturities of other issuers, including the five-year sovereigns of Austria, Netherlands and Finland. Beyond the five-year maturities, there is the 10-year Swiss sovereign, where yields have fallen into negative territory as well this year.

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In fact, bond yields of many large multinational issuers are also so suppressed that with almost no spread to account for over the yields of government debt, the large corporates have come to be regarded as the new safe havens, with the record cash balances of companies much stronger than Europe’s indebted governments.

To get any yield, investors need to increasingly climb up the credit-risk spectrum and consider lower, borderline investment-grade credit. It’s a risky proposition, given that credit spreads between highly rated AA and borderline investment-grade BAA have more than halved since 2012.

Such a downbeat outlook begs the question whether the bond markets now look overvalued longer term. Shorter term these levels may still be justified on the basis of the ECB’s quantitative easing (QE) and the lack of investment spending in Europe. But once QE in the eurozone unwinds after 2016 and investment spending picks up, these negative yields look unsustainable.

In the bond markets, there is considerable downside risk for investors. The first small rate hike by the US Federal Reserve is likely to set a precedent for investors to price in more rate hikes in the future, which will inflict capital losses and/or loss of higher-yields opportunities for investors seeking income.

Income-hungry investors searching for an alternative to the yield-deprived fixed income market may increasingly find the dividend stream of quality companies a viable alternative.

Major equity markets can now offer dividend yields of more than 3 per cent that exceed longer term government bond yields by several hundred basis points. Equity income exchange-traded funds (ETFs), with a strong emphasis on systematically screening and weighing stocks by dividends, can offer even higher dividend yields than market cap-weighted equity benchmarks.

Such fundamentally weighted ETFs, as opposed to market cap-weighted ETFs, can offer income investors the additional benefit of improved risk-adjusted returns, mainly because a dividend is a well-understood metric that is typically issued by companies that are confident in their business models, operate in stable sectors or are well-established multinationals. This in itself will emphasise the portfolio’s exposure to quality stocks and de-emphasise the exposure to speculative stocks.