From the March 2012 issue of Research Magazine • Subscribe!

Diving for Dividends

The aftermath of the credit crisis has dramatically changed the behavior of corporations. To appease financial markets, companies quickly reduced costs, ramped up productivity and have enjoyed record profits ever since. But the crisis also led to other unexpected changes: a mountain of corporate cash.

Bolstered cash levels have led to rising dividend payouts, showering shareholders with much needed income.

In 2011, S&P 500 companies paid $240.6 billion in dividends, which was up 17% compared to 2010. Last year’s dividends were also the highest rate since 2008. And for 2012, dividends are expected to top $252 billion, according to dividend data on almost 400 companies tracked by S&P. 

How can advisors tap into this wave of increasing dividends? And which ETFs can help them to boost their client’s income? 

Sector ETFs

Industry sector ETFs that concentrate on segments of the market where dividends are increasing or higher than broader benchmarks offer one strategy for capturing more income. Investing in individual stocks and depending on dividend income from one company increases a client’s risk, whereas owning a basket of stocks is the safer strategy.

“Preferred stock ETFs are another way to diversify,” said Mark Mappa, CFP at Fusion Financial Group in Glenview, Ill. The iShares U.S. Preferred Stock Index Fund (PFF) carries a dividend yield around 6.99% and owns around 240 stocks in various sectors including banking, insurance and real estate.

Financial services stocks inside PFF account for around 70 percent of its sector exposure, but dividends in the financial sector have been improving. The S&P financial sector doled out $28.5 billion in dividends last year compared to $18.6 billion in 2010. Promising as that may be, the financial sector still has its constraints. As a result of the 2008 bailouts, U.S. banks still need federal approval before they can increase dividends. PFF’s annual expense ratio is 0.48%.

For advisors looking to diversify away for U.S. securities, BlackRock also offers the iShares S&P International Stock Index Fund (IPFF). The fund has 82% of its exposure concentrated in the financial sector. The top countries represented inside IPFF are Canada (79.17%), United Kingdom (11.25%) and Sweden (4.78%). IPFF’s dividend yield is 2.04%.

Utilities are another sector that has a record of consistently high dividends.

The Utilities Select Sector SPDR (XLU) has a 3.80% yield and owns S&P 500 stocks that produce and distribute electricity along with natural gas. Among XLU’s 33 holdings are utility titans like Duke Energy, Exelon and Dominion Resources. Over the past year, utilities have bucked the stigma of being a dull and low return sector. In 2011, XLU gained 19.53%. XLU’s annual expense ratio is 0.18%.

Dividend ETFs

Another strategy for obtaining more income is ETFs that own stocks with a history of increasing dividends. Most of these dividend ETFs will also offer broader market coverage than what a sector fund can offer.

The SPDR S&P Dividend ETF (SDY) comprises the 60 highest dividend yielding stocks within the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years. While many dividend oriented equity ETFs are heavily concentrated in a handful of industries, like financials, SDY’s overall sector exposure is broader than most. Financial stocks make up just 19.23% of SDY, while consumer staples (18.7%), industrials (13.94%) and consumer discretionary (11.32%) are among the other top categories.

SDY is linked to the S&P High Yield Dividend Aristocrats Index. It carries a yield of 3.23% and charges annual expenses of 0.35%.

The Vanguard High Dividend Yield ETF (VYM) screens for stocks that pay high dividends. Although VYM has only yielded slightly more than the S&P 500 on a historical basis, it takes a conservative approach. With roughly 439 stocks, VYM is well diversified and loaded with blue chips like Exxon Mobil, Johnson & Johnson and Microsoft. The fund yields 3.44%.

Seeking dividends with a global bent? WisdomTree’s ETFs offer some interesting choices. For exposure to equity markets in developed countries ex-U.S., there’s the DEFA Equity Income Fund (DTH), International Large Cap Dividend Fund (DOL) and International Small Cap Dividend Fund (DLS). These particular WisdomTree ETFs carry dividend yields between 2.46 and 4.3%.

Municipal Bonds

There are other approaches to seeking income in a world of low interest rates. A negative news report on the 60 Minutes TV show about massive defaults in the municipal bond market in late 2010 scared many investors away. But instead of collapsing, munibonds increased in value. The Barclays Capital Municipal Bond Index, a widely followed barometer of national U.S. municipal bond performance, gained 10.7% in 2011. Also, credit quality did not fall apart at the seams as many strategists predicted. 

“Municipal yields, nominally, not even tax adjusted, have been at or higher compared to U.S. Treasuries over the past several months,” said Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global. “Right now represents a unique buying opportunity for investors.”

Most people compare the yields of municipal bonds to U.S. Treasuries with similar durations. For example, as of mid-January, 15-year munibonds are yielding 105% of U.S. Treasuries and 20-year munibonds are yielding 113% on average. Historically, the yield on tax exempt munibonds is 85% of Treasury yields.

For over four decades, the portion of rated munibonds that have defaulted is below 0.5%, according to research from Moody’s Investor Services and Standard & Poor’s.

Aggressive income seekers should look at the Market Vectors High Yield Muni ETF (HYD), which focuses on national munibond market but with lower credit quality. The 30-day SEC yield for HYD carries 5.62%.

The Market Vectors Intermediate Muni ETF (ITM) focuses on the national munibond market with durations of six to eight years. ITM also owns investment grade debt and carries a yield of 2.32%.

Astute advisors are cautious about chasing yield at the long end of the yield curve.

“I’m sticking with bonds that are short to intermediate term durations to get more yield than a savings account,” says Mappa. “But at the same time, I want to protect against a potential uptick in future rates, where the principal value would substantially decline.” 

Looking Ahead

In its January meeting, the Federal Reserve Board reiterated its goal of keeping short-term interest rates pegged near zero until 2014. That means low yielding income products like bank CDs and money market funds won’t be much help for income starved investors. An attractive way to help clients overcome the income shortages from living in a low rate environment is to take calculated risk in order to generate some yield.

 

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