Bonds: A Dividend Growth Investor's Best Friend?

Includes: AGG, JNJ, LQD
by: Dale Roberts

What do dividend growth investors like most? The growth part of the equation - the rising income.

What do bonds deliver? Income.

What if the dividends and bond income in a diversified portfolio were both increasing over time? Well that's the proverbial win - win. I find it ironic that there's such a panic about rising yields that would lead to immediate and long-term increased income from bonds and bond funds. Can you imagine a dividend growth investors crying "run for the hills Martha, I think Coke is going to increase its dividend again."

Certainly I understand the price risk of bonds. I have given that subject too much time over the last year. I have put some of those thoughts into articles such as Bonds: Don't Fear the Reaper. Within a balanced portfolio that holds a nice mix of stocks and bonds, the fear of rising rates is simply overdone in my opinion. And in the opinion of market history. But back to income.

Dividend growth investors hold companies largely for their rising income stream. On that same page income investors seeking rising income from their balanced portfolio (that mix of stocks and bonds) should embrace rising rates. Over the last few decades bond investors have been treated to some incredible total returns. In fact many bond portfolios have kept pace with the stock markets for a few decades. But the income stream (the yields) from bonds has been falling steadily.

Here's the income stream from the DEX Universe Bond Index ETF. The U.S. equivalent of course would be broad based bond ETFs such as (NYSEARCA:AGG). The trends are very similar. AGG has seen its income distributions fall by about half over the last several years. ishares corporate bond ETF (NYSEARCA:LQD) has also seen a steady income decline.

Here's the DEX income history.

The income from DEX has been falling steadily, essentially being cut by a third over a decade.

But yes, it's certainly been a total return treat over the last decade or more.

If an investor is seeking an increasing revenue stream from investments they should embrace rising rates. As I tell bond-leery clients every day - there's two sides to the bond coin during a period of rising rates. There's falling prices on one side. There's rising income on the other side of the coin.

Here's what happened over the spring and summer as we experienced a very pronounced spike in 10- and 20-year treasuries and the ripple effect across most bond categories.

We can see the DEX Universe Bond Index (a broad based bond index) moving from a sub 2.2% yield to a near 3% yield. Who doesn't like a 35% dividend increase? Er, make that a bond income increase. If (NYSE:JNJ) announced a 35% dividend increase there'd be a big party in dividend growth land. When a bond fund quickly delivers a 35% income increase (on purchase) investors are shaking in their boots. On the dividend growth side we read articles such as, Why Do Dividend Growth Investors Like Price Pullbacks So Much? There's not much of that spirit on the bond side. That should change.

For investors in the accumulation stage, there's the opportunity for new monies or reinvested income to instantly purchase a higher yield. And over time, and in a rising rate environment, your bond ETF will be able to purchase bonds offering higher yields. Over a longer cycle of rising rates, that will translate into bond funds delivering increasing distributions. A rising rate environment can also be beneficial to those who are drawing down against their portfolios, if that income is already at a sufficient level to satisfy spending requirements.

An income investor holding dividend growth stocks or ETFs (or even the broad based market indexes that deliver increasing dividends) and bond ETFs will have double barreled income growth. And mostly likely the bonds in tandem with stocks will continue to deliver on lowering portfolio volatility for those who keep an eye on the total return and portfolio value.

Here's how yields looked in a period of sustained rate increases.

Ya, give me some of that. I know, be careful what you ask for. But I'll take a period of modestly increasing rates that allow bonds to deliver higher income and some muted but positive total returns over a 5-10 year period. It would be the ultimate combination for an income investor to have increasing income in their equity holdings and their bond holdings. In fact, even those holding a classic balanced portfolio buying the broad market stock and bond indices would benefit on the income front.

Holders of balanced portfolios will have to take a page out of dividend growth investors' book and not "care" so much about any price volatility. And those with balanced portfolios should always remember that we don't have to consider our bonds in isolation, they're hanging with their perpetual sidekick - stocks. And in many periods, when bonds struggle, the stocks were there to say hop on, I'll carry you for a while. In the period show above 1950-1964, the typical balanced portfolio did extremely well on that total return front. Not only that, those balanced portfolios in that time period would have experienced that rising income from dividends and bonds.

Let's remember there are two sides to the bond coin.

Modestly rising rates? Sign me up.

Disclosure: I am long SPY, 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.

Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer the lowest-fee, managed, index-based portfolios available 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