Despite last week’s modest increase in the Federal Reserve’s discount rate, those investors seeking to generate income from their portfolios still face near-zero short-term interest rates in most developed markets.

According to Bloomberg, 3-month government bond (or bill) yields in the major markets are 0.08% (US), 0.49% (UK), 0.13% (Japan) and 0.28% (Germany).

Investors can pick up income by moving to longer maturities in the bond market: 30-year government bonds yield 4.70% in the US, 4.66% in the UK and 3.97% in Germany, for example. However, buying such long-dated instruments incurs capital risk if bond yields continue to climb, as they have for the last year.

And while corporate bond funds have attracted major inflows over the last year and performed handsomely, corporate yield spreads to government bonds have recently tightened to the point where some investors are questioning these bonds’ further attractiveness. For example, the spread of the iBoxx Euro Corporate bond index over equivalent maturity government bonds fell from a peak of 455 basis points early in 2009 to around 150 basis points last month.

So should income-oriented investors perhaps be looking at equities instead?

Two standout funds in the European exchange-traded fund equity income sector are iShares’ FTSE UK dividend plus ETF and the same firm’s DJ Euro Stoxx select dividend ETF. At current prices, these funds yield 4.17% and 3.53%, respectively – in the same ballpark as long-term government bond yields and a little less than corporate bond yields.

Both funds exhibited sharp increases in their payout ratios between mid-2007 and early 2009, with the distribution yield on the FTSE UK dividend plus fund rising from 4% to 12%, and the DJ Euro Stoxx Select dividend ETF showing an even steeper increase, from under 3% to nearly 13%. However, while the ETFs’ yields are now close to the levels of three years ago, this single metric tells only part of the story of the period.

The distribution yield figure given by iShares on its website combines a backward-looking measure (historical dividends) with share prices that are essentially forward-looking. From early 2008 equities began to price in expectations that dividends would be cut, and correctly so: many companies slashed their payouts later that year and in early 2009.

In an article published on IndexUniverse.eu last June we highlighted the areas of the European equity market that had suffered the most from declining dividends by focusing on the different supersectors in the DJ Stoxx 600 index. The review showed that financial stocks, construction companies, carmakers and airlines had suffered severe dividend cuts, while firms in the retail, food and beverage and oil sectors had maintained relatively steady payout policies.

1 | 2 |