22% Annual Dividend Growth: Courtesy Of Bonds

Includes: AGG, DIA, LQD, SPY, VIG, VYM
by: Dale Roberts

In my second article on the "Balanced Dividend and Income Growth Portfolio", I examined the income growth potential of two Dividend ETFs Vanguard's (NYSEARCA:VIG) and (NYSEARCA:VYM) held in concert with their income cousins from the bond side (NYSEARCA:AGG) and (NYSEARCA:LQD). I allocated $10,000 to each portfolio. I had first examined the income stream in the drawdown phase in this article here. That is, there was no reinvestment of dividends, and bond distributions, the income was harvested and 'enjoyed'.

We witnessed the effect of falling bond income over the last several years and the challenges of dividend ETFs trying to find their way during the great recession. The portfolio would have delivered on a 3% drawdown requirement, and it would have outperformed the S&P 500 (NYSEARCA:SPY) on a total return basis - in a portfolio with much lower price volatility.

So what happens when we reinvest the income from dividends and bond ETFs back into the holdings? Here's how that looked with equal reinvestment back into the dividend ETFs and the bond ETFs.

Start Date of January 2007.

ETF Dividends Bonds Total Growth
TOT 07 422 1033 1455
TOT 08 480 1076 1556 7%
TOT 09 428 1074 1502 -3%
TOT 10 441 1055 1496 0%
TOT 11 527 1051 1578 5%
TOT 12 641 1031 1672 6%
TOT 13 685 886 1571 -6%
Click to enlarge

Once again, we can see that even with reinvestment the bond ETFs are broken on the income growth front. But let's not confuse that with lack of income, it's still beating the pants off of the stocks in pure income. Why not, they call bonds income investments. But for income growth, that's simply not there.

So what if we deploy the strategy that I currently use in two of our retirement accounts? I take the combined income from dividend ETFs, broad market ETF indices (that have nice dividend growth of their own), a multi-asset class income ETF, and the bond ETFs and direct all of that income to the more reliable and growing income from the dividend ETFs.

In honour of a famous Seinfeld episode, let's call that move "The Cranky Maneuver".

How has that worked in practice? Here are the results in total return and income generation in one of our main retirement accounts, all income is tax sheltered. Below is the income and market value.

Click to enlarge
(Click to enlarge)

We can see that coming out of the recession and as I started to deploy the Cranky Maneuver there has been some very nice income growth. Let's discount the 2009 numbers, in order to not have an unfair low starting point, and use 2010 as a base point. I have income growth of 17% and 25%. Full disclosure; I did add $6000 to the above account in 2011 and $3000 in 2012.

In 2013, I fixed my home bias somewhat and switched out of higher yielding Canadian ETFs and moved more into Vanguard's VYM and the Dow Jones (NYSEARCA:DIA). One step backward (er jumping up and down in the same spot) for income, one step forward for international diversification. But hence, that income will likely be flat for 2013 from 2012.

My numbers are looking much better for 2013 than what appears above, but we'll leave those numbers alone for now. I'm hoping that some of my ETFs give my some very generous Christmas presents. Who doesn't love dividends under the tree? My portfolio value is heading towards $225,000 as well. That's another story in portfolio management. While fixing my home bias, I also fixed my overexposure to bonds, adding more equities. I now have more equities to bonds, but only marginally. Also, after a few years of being the "laggard", the Canadian markets have joined the party over the last 3-4 months. The Cranky Maneuver and rising markets (over time) will continue to add more growth potential, and reduce the impact of falling bond prices.

What happens when we apply the Cranky Maneuver to the VYM VIG AGG LQD portfolio?

Total Income Reinvestment to Dividend ETFs.

Start Date of January of 2007

ETF Dividends Bonds Total
TOT 07 435 991 1426
TOT 08 501 969 1470
TOT 09 470 927 1290
TOT 10 511 883 1394
TOT 11 630 853 1483
TOT 12 794 743 1538
TOT 13 932 656 1588
Click to enlarge

Well presto and magic (call the Shamwow TV late night gadget guy) we have incredible dividend growth. The total dividend income even passed the bond income, thankfully.

How much dividend growth? Let's look at the rates.

ETF Dividends Growth
07 Total 435
08 Total 501 15%
09 Total 470 -6%
10 Total 511 9%
11 Total 630 23%
12 Total 794 26%
13 Total 932 est. 17%
Click to enlarge

Over 6 years we now have a dividend compound annual growth rate of 13.5%, and that's moving through the Great Recession. In the good times, post recession, and with the gathering momentum of total income driving dividend growth, we have a dividend CAGR of 22% over the last 3 years.

We would expect that income growth to accelerate considerably as the equity to bond weighting shifts from the original 50/50 to 60/40 and then 70/30 and beyond in favour of equities and dividend growth. That shift could happen quite quickly. We can see in the above chart that the dividends overtook the bond income in year six.

There's also the possibility that bond income will start to increase over time. Writers and readers have been warning me of that event for some time - that rates will have to increase, and their implication is that those rates will increase real soon. I welcome that event. That would be a wonderful event if the dividends are increasing and the bond income is increasing. According to many the portfolio above has some bond income protection to the downside, as there's nowhere for rates to go, but up. We'll see. Rates could do anything.

If we extrapolate the above growth rate over the next 8 years (allowing for a 15 year total investment horizon) here's how the income breakdown or source of income might look. The bond income has hypothetically held steady.

  • Income from Dividends: $4573.
  • Income from Bonds: $650.

Dividends now comprise 86% of the investor's income. It's now a dividend growth portfolio with very modest bond exposure. Let's take that income growth to a more "modest" 15% growth we now have:

  • Income from Dividends:$2851
  • Income from Bonds: $650

Has the volatility (risk level) of the portfolio changed over time? One would think that's most likely the case with the increased concentration in equities. That said, risk would likely have been managed through any near term equity market fluctuations thanks to the presence of bonds. And if the equity markets do well, increasing the equity concentration and the total portfolio value, the risk of a more aggressive equity portfolio will also be managed.

There's nothing like success to temper the blow of a portfolio value decline.

Imagine an investor who started with $100,000 in the above scenario - and the portfolio has grown to $170,000. If the portfolio falls 30%, they have a value of $119,000. They haven't "lost money". Being in positive territory can help ease the blow for many investors. The same holds true for an investor who held 100% equities. If you have a fortunate start date allowing you to get ahead of the DG game, you may feel more comfortable with any price corrections allowing you to concentrate on the revenue stream. In the balanced approach, investors who have moderate risk tolerance can get over the hump and move towards a more concentrated and pure dividend growth portfolio. And of course, the investor has the ability to also reinvest income back into the bond ETFs moving the risk profile to the level of their choosing.

Imagine, getting incredible price protection and growing dividends? Get out the bib that says "I Love Dividends" you might have your cake and get to eat it too.

I'll leave you with this.

This appears to be a very strong strategy for managing price risk and growing income.

But true income investors bring out all of the weapons available and will invest in more generous yield opportunities such as utilities, REITs and some higher yielding bonds - moving that income into the dividend ETFs. As Miss Piggy would say, one of those investors would be "Moi!". I certainly like my yield pigs. I write that with sincere pun apologies to Miss Piggy.

In a future article, I'll look at that full income assault driving that dividend bus.

Disclosure: I am long VYM, DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.