Worried About Fixed Income Bubbles? Try A Dividend ETF

by on August 27, 2010 | Updated October 7, 2010 | ETFs Mentioned:

Despite bullish rhetoric from Washington and some indications of progress–the strength of the recent earnings season was a pleasant surprise–investors remain anxious in the current environment. With equity markets facing tremendous obstacles ahead, including elevated unemployment rates and an uncertain regulatory environment, safe havens have seen no shortage of interest [see Three ETFs To Protect Against A “Hindenburg Omen” Sighting].

The 18 month period between January 2009 and June 2010 saw an astonishing $232 billion flow out of equity markets. During that same period, a total of $559 billion was invested in fixed income, demonstrating that investors are clearly gravitating towards the low-risk/low-reward profile offered by bonds. Bond prices have soared and yields have plummeted in recent months, leaving more and more analysts worried that a bond bubble is forming. IF that is indeed the case, the unwinding could wreak havoc on what many consider to be today’s safest investments.

The U.S. has seen its fair share of bubbles in the past; the Tech bubble of a decade ago defied logic had but nevertheless attracted billions of dollars; with stocks selling at over 100 times their earnings in 1999 it should have been no surprise when most of these overvalued securities saw an 80% decline shortly thereafter. Some respected investors think the bubble now forming will be equally devastating. “The bond market is the mother of all bubbles right now and I think when it bursts the losses will dwarf the combined losses of the stock market bubble and the real estate bubble,” said Peter Schiff. “This decade will be the worst decade for bonds in U.S. history.” [see Seven ETFs Peter Schiff Might Not Hate]

Yields on many 10 year Treasuries have dipped below 1%, a paltry return that would have seemed impossible not that long ago. Despite these abysmal current returns, investors continue flocking to the safety of fixed income. “To boot, investors must pay taxes at the highest marginal tax rate every year on the inflationary increase in the principal on inflation-protected bonds—even though that increase is not received as cash and will not be paid until the bond reaches maturity,” write Jeremy Siegel and Jeremy Schwartz.

Part of the concern over the bond market comes from the current interest rate structure. Although it seems likely that the Fed will be keeping rates near zero for the foreseeable future, rates must eventually rise. If and when a tightening campaign begins, spiking rates will put downward pressure on fixed income securities [see also Long Term Bond ETFs: One Heck Of A Rally].

The economy is unlikely to hold its current pattern of instability, as markets historically trend into either a recession or prosperity rather than hover in between. No matter how the markets react, the potential for disaster in the bonds market exists. If a double dip is ahead, some think it’s possible that the government will eventually encounter difficulties servicing its considerable debt burden forcing the Fed to inflate its way out of trouble and crushing bond demand. Conversely, if the economy recovers to a healthy level, investors may leave fixed income for more attractive opportunities in equities.

Dividend ETF Options

For investors who are in search of current return but hesitant to chase an impressive rally in fixed income, Siegel and Schwartz offer a solution: funds with strong dividends. The thesis behind this investment strategy is that major companies are highly unlikely to disappear in the coming years, and dividends have historically increased annually at a faster rate than inflation. For investors fearful of the bond market, we outline several ETF options to beat the fixed income bubble  [see also this complete guide to dividend ETFs].

Claymore/Zacks Multi-Asset Income Index ETF (CVY)

This ETF tracks the Zacks Multi-Asset Income Index, a benchmark designed to identify companies with potentially high income and superior risk-return profiles as determined by Zacks Investment Research, Inc. With about 150 securities, including companies such as ConocoPhillips (1.3%) and Chevron (1.3%), CVY maintains balanced exposure to various sectors of the economy [see all of CVY's holdings here]. This ETF exhibits a dividend yield of close to 5%, a current income hard to find in the fixed income space.

iShares S&P Global Energy Index Fund (IXC)

iShares‘ IXC follows the S&P Global Energy Sector Index, a benchmark that measures the performance of the energy sector of global equity markets. Exxon Mobil (15%) and Chevron (7%) account for the top two holdings of this ETF, and both companies are among the top dividend paying firms in the U.S. Though the energy sector has taken a hit this year, IXC pays a nice dividend and may be worth a closer look for yield-starved investors [see all of IXC's fundamentals here].

iShares Dow Jones U.S. Real Estate Index Fund (IYR)

IYR seeks to replicate the Dow Jones U.S. Real Estate Index, a benchmark that measures the performance of the real estate industry of the U.S. equity market. This ETF holds almost all of its assets in U.S. based securities, the majority of which are of medium market capitalization size [see IYR's fact sheet here]. Like many ETFs in the Real Estate ETFdb Category, IYR makes a dividend payment that many investors will find appealing.

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Disclosure: Photo courtesy of Mila Zinkova. No positions at time of writing.