Dividend ETFs vs. Bond ETFs: Here's Which One Makes More Sense for Income Investors in This Market

Income-focused investors often face a dilemma. Do they invest in lower-risk fixed-income investments like bonds, or take on more risk to potentially earn a higher return from dividend stocks?

However, one risk factor most investors don't consider is the current market environment, which can meaningfully shift the risk/reward balance. Here's a look at whether it makes more sense to invest in dividend or bond ETFs in today's market.

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The risk of fixed income in the current environment

Bonds provide investors with a stream of fixed income from interest payments. It can be highly bankable income, especially if the bond is from a high-quality issuer such as the U.S. Government or an investment-grade company. That fixed return makes bonds fairly low-risk investments.

ETFs make it easy to invest in bonds for income. A top option is the Vanguard Total Bond Market ETF (NASDAQ: BND). The fund invests in taxable investment-grade U.S. dollar-denominated bonds, excluding inflation-protected and tax-exempt bonds. It currently holds nearly 11,500 bonds. Its portfolio has an average coupon of 3.9%, though the yield to maturity is higher at 4.7% due to the value it purchased its bond holdings. It primarily invests in longer-term bonds and has an average yield-to-maturity of more than eight years. As a result, it should provide investors with a low-to-mid single-digit annual income yield for the next several years.

There's just one problem. Inflation is currently running at a 3.5% annualized rate. While that's down from 4.2% the prior month, inflation would steadily eat into the income produced by this bond ETF, eroding the purchasing power of an investor's income over time.

The case for dividend growth in an inflationary environment

Income investors would face the same inflationary impact on their dividend income whether they invested in a stock or an ETF that pays a stable dividend. However, many stocks pay steadily rising dividends. That dividend growth would help them overcome inflation's impact and generate a real return.

Several ETFs focus on dividend growth stocks. One notable option is the S&P 500 Dividend Aristocrats® ETF (NYSEMKT: NOBL), which focuses on companies that have increased their dividends for at least 25 consecutive years (the term Dividend Aristocrats® is a registered trademark of Standard & Poor's Financial Services LLC). That growth does two things. It increases the income paid by the fund while also growing the value of its shares:

NOBL data by YCharts

While the ETF offers a lower income yield compared to a bond right now (over 2%), the income stream should steadily grow over time, likely at a much faster rate than inflation. This growth in both dividend income and share value has enabled the fund to deliver an average annual total return of 10.7% since its inception in 2013, more than offsetting inflation.

Dividends make more sense while inflation remains high

The fixed income offered by bond ETFs seems less risky than dividend income. However, that doesn't account for the currently elevated inflationary environment, which would quickly erode the purchasing power of fixed income. That's why investing in dividend growth stocks makes more sense right now. A fund like the S&P 500 Dividend Aristocrats® ETF should provide a growing stream of dividend income and price appreciation, more than offsetting inflation's impact.

Matt DiLallo has positions in Vanguard Total Bond Market ETF. The Motley Fool has positions in and recommends ProShares S&P 500 Dividend Aristocrats ETF and Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.