September 25, 2012 at 06:00 AM EDT
The Best Place to Look For Income Today
It's a good rule of thumb: when stocks yield more than bonds, stocks are the better buy because of the potential for growth. Believe it or not, before the financial crisis in 2008 that was hardly the case. Going all the way back to 1958, bond yields always outpaced those of stocks. But thanks to Ben Bernanke and friends, bond yields have been driven into the basement. What's more, the central banks of the world are doing everything in the power to keep them there. That's why investors are increasingly turning to exchange-traded funds that specialize in dividend stocks as vehicles for income. This makes good sense for a couple of reasons. First, bond markets aren't very transparent, which makes bond prices difficult to come by, so ordinary investors get ripped off if they buy corporate bonds directly. Second, in today's markets you will do better in a high-dividend stock ETF--especially one with an international portfolio, than you will in a bond ETF. Let me show you why that is...
It's a good rule of thumb: when stocks yield more than bonds, stocks are the better buy because of the potential for growth.

Believe it or not, before the financial crisis in 2008 that was hardly the case. Going all the way back to 1958, bond yields always outpaced those of stocks.

But thanks to Ben Bernanke and friends, bond yields have been driven into the basement. What's more, the central banks of the world are doing everything in the power to keep them there.

That's why investors are increasingly turning to exchange-traded funds that specialize in dividend stocks as vehicles for income.

This makes good sense for a couple of reasons. First, bond markets aren't very transparent, which makes bond prices difficult to come by, so ordinary investors get ripped off if they buy corporate bonds directly.

Second, in today's markets you will do better in a high-dividend stock ETF--especially one with an international portfolio, than you will in a bond ETF.

Let me show you why that is...

Stock ETFs vs Bond ETFs To see why stock ETFs are a better deal than bond ETFs, let's run through the five bond offerings of iShares, one of the largest and most solid creators of ETFs:
  • Aggregate Bond Fund (NYSE:AGG): Buys investment grade corporate, Treasury and agency bonds, mostly AAA-rated, with an average maturity of 6.2 years. Yield in the last 30 days, as calculated by the SEC: 1.61%.
  • Investment Grade Corporate Bond Fund (NYSE:LQD): Buys mostly corporate bonds with an average Standard and Poor's rating of A, and an average maturity of 11.9 years. Yield: 2.97%.
  • High Yield Corporate Bond Fund: (NYSE:HYG): Buys high-yield "junk" corporate bonds with an average S&P debt rating of B+ and an average maturity of 4.34 years. Yield: 5.50%.
  • JP Morgan Emerging Markets Bond Fund (NYSE:EMB): Tracks the JP Morgan "EMBI" emerging markets bond index. Average rating about BB-, average maturity 12.02 years. Yield: 3.58%.
  • Emerging Markets Corporate Bond Fund (NYSE:CEMB): Average rating BBB, average maturity 7.99 years. Yield: 3.26%.

Now can you see the problem?...

In order to get a yield above 3% with decent credit risks, you have to go out beyond 10 years in average maturity. In the current environment 10 years is a long time.

What will happen to your investment if rates begin to rise? (I say if, but let's face it, the interest rate bubble cannot last forever.)

Notes of this duration leave you vulnerable to a huge amount of price risk if interest rates rise, because a 12-year bond will decline almost 10% in price if yields just rise 1% per annum.

On the other hand, to get a yield above 5%, investors in these funds have to go down to a credit quality that will be in severe danger if the U.S. economy goes back into recession (or again if interest rates rise, since low-rated companies may not have cash flow to cover higher interest.)

Investing For Income and Growth Out of that group only the two emerging market bond funds would have any appeal to me. Forced to choose, I would go for the corporate fund, which has a higher average rating and only a modestly lower yield.

One of the little known secrets about emerging-market bond investing is that the indexes and most funds are weighted towards the countries like Argentina, Russia and Brazil, which have the most debt outstanding - and are thus the lousiest credits.

A corporate bond fund, on the other hand, is weighted towards the countries with the most corporate debt, which at least requires them to have some kind of functioning private sector!

But's let's not forget that rule of thumb. Smart investors are going for income and growth.

From the same universe of ETFs, iShares offers dividend funds on stocks that look much more interesting.

Domestically, that includes the High Dividend Equity Fund (NYSE:HDV), correlated to the Morningstar Dividend Yield Focus Index. This fund yields 3.54% while owning companies like Altria Group Inc. (NYSE:MO) and Johnson & Johnson (NYSE: JNJ)

Internationally, the iShares Dow Jones International Select Dividend Index Fund (NYSE:IDV), correlated to the index of that name, yields 4.98%. Similarly, it's Emerging Market Dividend Index Fund (NYSE:DVYE) yields 3.75% and its Asia/Pacific Dividend 30 Index Fund (NYSE:DVYA) yields 5.62%.

The advantage of these dividend funds is that, being broad based, their dividend yield is just about as reliable as a bond yield and should increase with inflation and economic growth.

Of course, their price will go up and down with the stock market, but there isn't the imminent one-way price risk of a bond fund. Again, yields can hardly get much lower from here.

And believe me, you don't want to be anywhere near the bond market when it finally bursts.

In fact, for the next nine years "cash harvesting" is going to be the only way for investors to earn long-term returns.

Today, that means buying high-yield stocks -- not bonds.

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About the Author

Martin Hutchinson has nearly 30 years’ experience as a global investment banker – plus a reputation for being bearish at just the right time. Slate magazine singled him out as the financier who most accurately predicted how bad the 2009 bear market would turn out to be. Martin is the editor of the Permanent Wealth Investor, where he focuses on stocks that pay high, reliable dividends. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. Learn more about Martin on our contributors page.

View articles by Martin Hutchinson

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