Erosion of Dividend Yields in Inflation-Linked ETFs: A Cautionary Trend for Income Investors?

Income investors have long turned to inflation-linked ETFs as a bulwark against rising prices, but recent trends suggest a troubling divergence between nominal yields and real-world purchasing power. As global inflation surged post-2020, these funds—designed to hedge against cost-of-living pressures—have seen their dividend yields erode, raising questions about their long-term viability for income generation.

The Paradox of Inflation-Linked ETFs

Inflation-linked ETFs, such as those tracking Treasury Inflation-Protected Securities (TIPS), have historically offered a dual benefit: capital preservation and income. For instance, TIPS-based ETFs like iShares TIPS Bond ETF (TIP) delivered a 0.48% return in Q2 2025, with a year-to-date total return of 4.67%, driven by sustained inflation risks [1]. However, this performance masks a critical flaw: while TIPS adjust principal for inflation, their dividend yields—derived from fixed coupon rates—remain static. As a result, investors face a paradox: rising inflation boosts principal value but does not inherently increase income streams.

Erosion Amid Structural Shifts

The decline in dividend yields is not confined to TIPS. Equity-focused inflation-linked ETFs, such as Schwab U.S. Dividend Equity ETF (SCHD) and iShares Dividend Growth ETF (DGRO), have also seen yields contract. DGRO, which targets companies with a history of dividend growth, saw its yield decline amid 2022–2024 inflationary pressures, despite its focus on resilient sectors [5]. Similarly, Vanguard Dividend Appreciation ETF (VIG) faced yield compression as rising interest rates pressured valuations of high-dividend stocks [3].

This erosion reflects broader structural shifts. The BlackRock 2025 Fall Investment Directions report notes that traditional diversification strategies—such as the negative correlation between stocks and bonds—have weakened, forcing investors to seek alternatives like commodities and digital assets [5]. Yet, these alternatives often lack the income-generating potential of dividend-paying equities, creating a gap in sustainable yield strategies.

The High-Yield Trap

High-yield bonds and structured products, such as the Western Asset High Income Opportunity Fund (HIO), have offered tempting yields (e.g., 10.76% as of 2025) but come with significant risks. HIO’s 17.09% price drop in 2022 underscores the vulnerability of high-yield portfolios to rate hikes and economic volatility [2]. While these funds may provide short-term income, their sustainability hinges on credit quality and macroeconomic stability—factors that remain uncertain in a high-inflation environment.

Sustainability: Beyond the Yield

The sustainability of dividend yields in inflation-linked ETFs depends on two critical factors: payout ratios and corporate fundamentals. Companies with payout ratios below 50% (e.g., Visa) are better positioned to maintain or increase dividends during downturns [1]. Conversely, high-yield ETFs with elevated payout ratios (often above 75%) face greater risk of cuts, eroding both income and capital [4].

Moreover, the S&P 500’s dividend yield of 1.5% serves as a benchmark, but its inflation-adjusted returns have averaged just 3.8% since 1957 [2]. This highlights the challenge of generating real returns in an environment where nominal yields fail to outpace inflation.

A Path Forward for Income Investors

For investors seeking sustainable income, the key lies in balancing yield with resilience. Diversification into alternatives—such as inflation-protected bonds, dividend growth stocks, and commodities—can mitigate erosion risks. However, as the Hartford Funds’ analysis notes, dividend growth-oriented portfolios historically outperform high-yield counterparts in volatile environments, thanks to their focus on reinvestment and earnings growth [1].

Conclusion

The erosion of dividend yields in inflation-linked ETFs signals a cautionary trend for income investors. While these funds remain a hedge against inflation, their ability to sustain income is increasingly contingent on structural market dynamics and corporate health. Investors must move beyond yield-centric strategies and prioritize long-term sustainability through diversified, fundamentals-driven allocations.

Source:
[1] BBH Inflation-Indexed Fixed Income Quarterly Update [https://www.bbh.com/us/en/insights/capital-partners-insights/bbh-inflation-indexed-fixed-income-quarterly-update-q2-2025.html]
[2] Average Stock Market Return | Historical Trends and What ... [https://www.businessinsider.com/personal-finance/investing/average-stock-market-return]
[3] The Seven Best Vanguard Funds for 2025 & Beyond [https://www.independentvanguardadviser.com/the-seven-best-vanguard-funds-for-2025-beyond/]
[4] Gen Z Investors Chase High Dividend-Paying ETFs in 401 ... [https://www.bloomberg.com/graphics/2025-gen-z-dividend-investing-etfs/]
[5] 2025 Fall Investment Directions: Rethinking diversification [https://www.blackrock.com/us/financial-professionals/insights/investment-directions-fall-2025]