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If you're looking to generate income in your portfolio, you have a huge problem right now. Bonds -- especially ones with a U.S. government-backed guarantee of repayment -- pay incredibly low interest rates. If you're willing to lock your money up with Uncle Sam for 10 years, for instance, you'll only get a 1.8% interest rate on your money.
That's well below the rate of inflation, and since standard U.S. Treasury bonds pay fixed coupons, all that really means is that you'd be buying a government-backed guarantee that your money will lose purchasing power. It's not exactly an exciting -- or a particularly rewarding -- way to invest, but it is the current reality of the bond market.
Is there a better way?
But what if you could find an investment that:
- Pays better current income than those 10-year Treasury bonds.
- Has the potential to raise its payout over time.
- Could also provide some capital growth.
Wouldn't that be worth considering in lieu of those Treasuries and their abysmal payouts? Fortunately, there is a mutual fund that's designed to seek out rising dividends that has the potential to deliver on the other targets as well: the Vanguard Dividend Growth (FUND: VDIGX ) fund. With a 2.24% yield, its income already comes in ahead of those 10-year Treasuries. And by owning stocks with histories of and commitments to raising their dividends over time, the fund's payouts can increase as well.
Of course, any dividend-oriented investing strategy can be problematic if a fund's expenses are high enough to chew through investors' returns. Fortunately, with a mere 0.34% expense ratio and a low 13% turnover, this Vanguard fund keeps its costs low enough so that most of the net benefit of those dividends flow through to fund holders.
Peeking under the hood
One of the fund's biggest holdings is PepsiCo (NYSE: PEP ) , the beverage and snack food giant behind Pepsi, Quaker, Fritos, and Doritos, just to name a few. With a 40-year history of increasing its dividend, a 3.1% yield, and a 51% payout ratio, PepsiCo is exactly the sort of company that would make sense to own in a fund looking for an ever increasing income stream.
Also on the fund's top holding list is Target (NYSE: TGT ) , the iconic purveyor of "cheap chic" merchandise. Target actually tops PepsiCo's history, with a 44-year trend of raising its annual payments to shareholders. And while Target's 2.2% yield is lower than PepsiCo's, Target's lower 27% payout ratio does give it a bit more room to grow its own dividend.
Occidental Petroleum (NYSE: OXY ) , an oil and gas exploration company with a 10-year history of increasing its payout, a 2.7% yield, and a 23% payout ratio, was the fund's top holding as of March 30. Occidental may be a newer member to the dividend growth party than PepsiCo or Target, but it still has laid a strong foundation as a company capable of rewarding its shareholders with regularly increasing payouts.
Of course, as an investor, you have the ability to buy those stocks -- or any of the fund's other 45 holdings -- on your own, rather than through the fund. But what the fund gives you is a one-stop shop of companies that have the capacity to make and grow their dividends over time.
It's also a pretty well-diversified fund. No industry currently represents more than 16% of the fund's portfolio, and even its largest holding carries only a bit more than three times the weight of its smallest position. For the fairly low 0.34% expense ratio, it's likely worth the price tag to not have to deal with the headache of managing your own dividend-paying portfolio.
What could go wrong?
Of course, unlike Treasury bond interest, dividends do not carry a government-backed guarantee of being paid. Like many other income-oriented investments, this fund's income took a hit during the recent financial meltdown. This was driven in large part by the fund's own exposure to financial titans Bank of America (NYSE: BAC ) and Citigroup (NYSE: C ) , which were forced to slash their dividends during the crisis.
Still, despite that bobble, the fund's diversified portfolio has enabled it to continue distributing decent amounts of cash, even as those financial titans stumbled. Indeed, the fund's 2011 dividend payment was more than 14% higher than its 2010 payment, as companies began recovering from the collapse and many resumed raising their payouts.
And if you were investing in this strategy on your own but hadn't been as diversified as the Vanguard Dividend Growth fund? Well, let's just say that there were worse places to be invested during that meltdown. All told, and even with the chance that dividends can again get slashed, Vanguard's Dividend Growth fund has a solid strategy, low costs, and decent prospects. That combination makes it one of the few mutual funds worth considering.