Construct a Fixed Income Portfolio with 5%+ Dividends Using ETFs

There were two superpowers in the world – the United States and Moody’s bond-rating service – and it was sometimes unclear which was more powerful.

-- Thomas Friedman, NY Times columnist.

Fixed income investment can be risky too. For example, in 2008 140 issuers defaulted on $7.6 billion in municipal bonds; during 2007, there were only $226 million in defaults, according to an article on August 31’s The New York Times. It is impossible for individual fixed income investors to go through all those bonds ratings and figure out which one is safe and sound.

ETFs, of course, are purported to be the solution to this problem. However, an ETF is a black-box type of investment. It is much harder to analyze an ETF than a company. We can still figure out the best ETFs by various criteria such as liquidity, price volatility and dividend stability, etc.

Liquidity

From a total of 835 ETFs, I filtered out those ETFs with net assets less than $100 million and average volume less than 100,000. Since the most populated fixed income ETFs such as iShares Barclays Aggregate Bond (AGG) and iShares Barclays TIPS Bond (TIP) only have yield around 3.5%- 4%, I had to pick the rest of ETFs with at least 5% yield so the portfolio can have an average of 5%. The following table shows 21 highly liquid ETFs.

#	Fund Name	Ticker	52-Wk-High/Low
1	Vanguard Total Bond Market ETF	BND	1.18
2	iShares Barclays Intermediate Credit Bd	CIU	1.21
3	iShares Barclays Aggregate Bond	AGG	1.21
4	iShares Barclays TIPS Bond	TIP	1.27
5	iShares Barclays 20+ Year Treas Bond	TLT	1.41
6	iShares iBoxx $ Invest Grade Corp Bond	LQD	1.39
7	iShares iBoxx $ High Yield Corporate Bd	HYG	1.51
8	SPDR Barclays Capital High Yield Bond	JNK	1.67
9	PowerShares High Yield Corporate Bond	PHB	1.71
10	iShares MSCI Taiwan Index	EWT	1.94
11	SPDR S&P Dividend	SDY	2.11
12	PowerShares Emerging Mkts Sovereign Debt	PCY	2.16
13	WisdomTree Europe Total Dividend	DEB	2.16
14	iShares MSCI Spain Index	EWP	2.17
15	Vanguard European Stock ETF	VGK	2.24
16	iShares Dow Jones Select Dividend Index	DVY	2.49
17	iShares S&P U.S. Preferred Stock Index	PFF	2.70
18	PowerShares Preferred	PGX	2.87
19	iShares Dow Jones US Real Estate	IYR	3.22
20	Vanguard REIT Index ETF	VNQ	3.46
21	PowerShares Financial Preferred	PGF	3.77

Volatility

For fixed income, the less volatility, the better. For this reason, I sort the list above with 52-week-high/52-week-low ratio. For example, Vanguard Total Bond Market ETF's (BND) last 52 week price range was $67 - $79, while PowerShares Financial Preferred's (PGF) was $5 - $19. Clearly PGF is much more volatile than BND.

Dividend Stability

In the list above, I have to get rid of the bottom 5, which have a high/low ratio greater than 2.5. In #6 - #16, there are 4 types: iShares iBoxx $ Invest Grade Corp Bond (LQD), high yield, PowerShares Emerging Mkts Sovereign Debt (PCY) and dividend stock ETFs.

Below 4 charts show 4 sample ETFs' dividend histories. As you can see, LQD, high yield and PCY all have pure stable dividend history. However, DVY’s dividend pattern is far from stable.

To sum up, I would pick one or two ETFs from #1 - #5 as my core holding, such as TIP and AGG. Then based on your risk tolerance, you can pick a few from #6 - #16, such as LQD, HYG and PCY. However, HYG and PCY only have a two-year history, so they might not be suitable for conservative investors.

Of course you can dig deeper into each ETF’s holdings and find out which company/bond/country they hold. In doing so, you can find out each company’s dividend payout ratio. Dividend payout ratio is the percentage of earnings paid to shareholders in dividends. It is calculated as dividend/net income. However, lots of companies calculate it as dividend/operation income, which results in a much lower payout ratio.

Disclosure: I have a long position on TIP. All data is from Yahoo Finance as of Sep 4, 2009.

Comments

[TAS:]

Nice effort on this post.

Although there are more vagaries than you reported for many (if not all) of the ETFs, I like your attempt to impose risk tolerance on seemingly "safe" income oriented ETFs.

Sep 09 10:59 AM

[No Free Cake:]

Was anyone else confused reading this? If the author is going to discuss bond ETFs in the same breath as equity ETFs he should be clearer what sentences pertain to what.

Such as when he suggests digging into each ETFs holdings to determine each company's payout ratio. How does that apply to the bonds, REIT, or even preferred stock ETFs mentioned? Huh?

And, frankly, talking about "dividends" for equities and bonds at the same time is very odd to me. Bond prices, by definition, hover around some baseline (par) whereas equity pricing has no similar bound.

There are some potentially interesting ideas here, but, I think better care should have been taken in the presentation.

Sep 09 03:49 PM

[Econ Base:]

The key question is what portion of your assett allocation should pursue such ETF's? Sorry, but I wouldn't park my "safe" money in this. As you mentioned the least voltalie of your picks is BND which has a 52 wk High/low price ratio of 1.18. 18% price decline too much risk to chase 5% dividend. You are better off with buying CD's for the safe portion of your portfolio. For the risky portion of your portfolio, maybe yes.

portfolioforlife.blogs...

Sep 09 04:07 PM

[TLassen:]

well I think Mr Jin did an excellent job, thanks very much for your efforts on this post.

Sep 09 04:11 PM

[MarkitWacha:]

Any investment in bonds right now is also a bet that the risk aversion seen in December '08 will not return, and that credit spreads between treasuries and bonds will decrease.

Because of those, it would be less risky to use credit arbitrage than to buy/hold bond funds. Or, use a corresponding hedge position via CDS or options. Look at the volatility of the 'risk-free' rate, via TLT. It doubled this year. The simple buy/hold strategy for bonds is not useful.

Long: put options on TLT, using the deltas to assist with range trades, and I'm waiting for the next global equities correction before entering into commodities, as a hedge against an eventual dollar mini-collapse.

Sep 09 04:35 PM

[Timmothy Posey:]

I'd add PGF to the list. It's the preferred shares ETF of financials, and pays nearly 9% by itself.

Sep 09 06:07 PM

[FB5000:]

A little confusing and I don't think he was clear on the salient points.

Higher returns drive higher risk

You have three sorts of risk with bonds

1. Interest Rate risk - shorter is better
2. Default risk - higher rated is better
3. Inflation risk

Long dated bonds are not returning enough to mitigate the risks - especially High grade corporates like LQD which is now returning fractionally more than the 10 year.

Buying the 10 year now is asking for trouble - you have to worry about #1 and #3.

In "safer assets" - TIP's are probably a better bet.

In "riskier assets" - lowergrade corporates and munis are probably paying you for the risk you are taking

I would go with a mix of TIP's, Munis's (there are some good CEF's), lower grade Corporates and Foreign - especially the emerging markets - where default risks are coming down - gives you a pop and the inflation protected bonds - there a couple of ETF's and CEF's out there.

Sep 09 06:17 PM

[trick:]

I like the dividend charts however I would have liked to see comparisons of each ETF's standard deviations for the volatility gauge instead of the 52 week high/low, and I thought you would have published the yield of each ETF since you refer to using this for construction.

I struggle with the payout ratio suggestion. If you're looking at the individual companies you would want to look at their interest coverage ratio (preferably on a forward looking basis) to gauge credit quality. If you're looking for an indication of yield you will have to look at the current trading yield of the individual issues also. Then there's the matter of duration, which along with credit quality is going to have the most impact on your bond fund performance, rather than yield. How is each ETF positioned along the yield curve? Just looking at the current running yield is really only meaningful for short-term issues.

Sep 09 07:41 PM

[Innocex:]

In your opinion, how much risk is there to low grade corp bonds in the event of an interest rate hike? I seem to get mixed messages on this point, thanks


On Sep 09 06:17 PM FB5000 wrote:

> A little confusing and I don't think he was clear on the salient
> points.
>
> Higher returns drive higher risk
>
> You have three sorts of risk with bonds
>
> 1. Interest Rate risk - shorter is better
> 2. Default risk - higher rated is better
> 3. Inflation risk
>
> Long dated bonds are not returning enough to mitigate the risks -
> especially High grade corporates like LQD which is now returning
> fractionally more than the 10 year.
>
> Buying the 10 year now is asking for trouble - you have to worry
> about #1 and #3.
>
> In "safer assets" - TIP's are probably a better bet.
>
> In "riskier assets" - lowergrade corporates and munis are probably
> paying you for the risk you are taking
>
> I would go with a mix of TIP's, Munis's (there are some good CEF's),
> lower grade Corporates and Foreign - especially the emerging markets
> - where default risks are coming down - gives you a pop and the inflation
> protected bonds - there a couple of ETF's and CEF's out there. <br/>
>

Sep 10 09:34 AM

[YoYoMama:]

A portfolio built only on ETFs and CEFs means each and every pick has a expense fee tacked onto it. This equates to a total reduction of payout of 1 - 2 %.

Why not cherry-pick among the best ETFs/CEFs, and mix with a larger selection of stocks, which have no management expenses?

ETFs and CEFs are not necessarily "safer" than quality stocks, and you pay management fees for the priviledge of owning them.

Sep 10 10:13 AM

[searcher:]

Very few who would follow the commendable rigor of 'trick's' research are going to be impressed by the 'convenience' of an ETF or even a CEF.

Sep 10 11:53 AM

[sacking:]

Thanks for your analysis. I use BND, HYG and JNK for the bond portion of my etf portfolio and also have VNQ in my equity portion, so I was quite happy to see my choices reflected in your article.

I'm building a 60/40 bond/equity portfolio with the etfs mentioned above in the bond portion. It's working out pretty nicely at this point.

Thanks again.

Sep 10 01:51 PM

[mbkelly75:]

I also use the Bond ETFs in his analysis and thank him for his work on this. I have a portfolio that is 34% Bond ETFs, 6-16% PM represented by CEF (giving me both Gold and Silver in a clear and transparent, easily tradable way that actually pays a small dividend), 50-60% dividend-paying stocks. I have the portfolio account set up to automatically re-invest dividends and interest in the security that paid them. If I need cash that month, one click gives me cash and one more click sends it back to the automatic setting. I check every two weeks to see if it needs re-balancing and re-balance when it is needed. You might think about something similiar for yourself.


On Sep 10 01:51 PM sacking wrote:

> Thanks for your analysis. I use BND, HYG and JNK for the bond portion
> of my etf portfolio and also have VNQ in my equity portion, so I
> was quite happy to see my choices reflected in your article.
>
> I'm building a 60/40 bond/equity portfolio with the etfs mentioned
> above in the bond portion. It's working out pretty nicely at this
> point.
>
> Thanks again.

Sep 10 02:56 PM

[FB5000:]

My opinion. Very simplistically.

Junk bonds behave more like equities than bonds. As rates begin to rise - if they rise becaause conditionas are improving they will not be impacted and could rise in value as the preceiveddefault risk reduces. Toward the latter stages of any cycle they will be crimped by rises as it presages a deterioration in conditions and slow down. High grade coorporates will run in the opposite way.


On Sep 10 09:34 AM Innocex wrote:

> In your opinion, how much risk is there to low grade corp bonds in
> the event of an interest rate hike? I seem to get mixed messages
> on this point, thanks

Sep 10 06:15 PM

[jmezerhane:]

On corporate bonds you should also consider liquidity risk.
Shorter is not always better, with a shorter bond you have lower interest risk but higher reinvestment risk. On a scenario of declining rates is better to go with longer mature periods. The opposite on a scenario of increasing rates.




On Sep 09 06:17 PM FB5000 wrote:

> A little confusing and I don't think he was clear on the salient
> points.
>
> Higher returns drive higher risk
>
> You have three sorts of risk with bonds
>
> 1. Interest Rate risk - shorter is better
> 2. Default risk - higher rated is better
> 3. Inflation risk
>
> Long dated bonds are not returning enough to mitigate the risks -
> especially High grade corporates like LQD which is now returning
> fractionally more than the 10 year.
>
> Buying the 10 year now is asking for trouble - you have to worry
> about #1 and #3.
>
> In "safer assets" - TIP's are probably a better bet.
>
> In "riskier assets" - lowergrade corporates and munis are probably
> paying you for the risk you are taking
>
> I would go with a mix of TIP's, Munis's (there are some good CEF's),
> lower grade Corporates and Foreign - especially the emerging markets
> - where default risks are coming down - gives you a pop and the inflation
> protected bonds - there a couple of ETF's and CEF's out there. <br/>
>

Sep 11 09:46 AM

[jmezerhane:]

in a 52 week range includes Lehman bankrupt... Even a CD won't be considered "safe" on those days. these last 12 months has been one of the worst months for FI ever.
The CD does not have the same liquidity than a FI ETFs



On Sep 09 04:07 PM Econ Base wrote:

> The key question is what portion of your assett allocation should
> pursue such ETF's? Sorry, but I wouldn't park my "safe" money in
> this. As you mentioned the least voltalie of your picks is BND which
> has a 52 wk High/low price ratio of 1.18. 18% price decline too
> much risk to chase 5% dividend. You are better off with buying CD's
> for the safe portion of your portfolio. For the risky portion of
> your portfolio, maybe yes.
>
> portfolioforlife.blogs...

Sep 11 09:56 AM

[Innocex:]

Thanks for your time FB5000 and jmerzerhane, excellent points

Sep 11 12:50 PM