From the July 2012 issue of Investment Advisor • Subscribe!

Finding Yield in Unusual Places

The ETF universe houses some surprising high-yield plays

Illustration by <a href="http://www.ellenweinstein.com/">Ellen Weinstein</a> Illustration by Ellen Weinstein

Investors who need yield—and there are many of them, from retirees to the young and risk-averse—have not had an easy time over the past couple of years, as interest rates fell to historic lows, only to drop even lower. The Federal Reserve’s low interest rate policy, slated to last until 2014, according to Fed chief Ben Bernanke, means that investors will get no relief through traditional avenues such as money market accounts, certificates of deposit and short-term Treasuries.

So what’s an income-seeker to do, beyond accepting less income? Many investors have turned to riskier assets, starting with longer-term Treasuries and corporate bonds and then slowly, gingerly moving down the quality ladder.

Last year, net inflows into bond funds and bond exchange-traded funds (ETFs) totaled $261 billion, according to Morningstar, as investors increasingly turned to bonds to help augment the income generated by their portfolios. A bond-focused strategy can create higher levels of income but can also add interest-rate and other risks.

More income, less risk?

One time-honored way to mitigate risk is through diversification, which works for income as well as growth. In the great search for yield, Envestnet|PMC uncovered some sectors of the markets where you might not expect to find good sources of income. We searched the ETF universe for strategies that were yielding more than 5% (using the previous 12-month yield) and found high-yielding examples in 23 out of the 88 different ETF categories (results were similar when examining mutual fund categories). While the usual suspects—high-yield bonds, preferred and emerging market debt—were in the mix, there were some surprises in both equity and alternative categories.

Employing research from Morningstar, we found that 46 out of the total universe of 1,434 ETFs (or 3.2%) have yields greater than 5%. Many of these ETFs are small, carrying their own kind of risk. Their total assets were slightly above $49 billion out of the total ETF universe of $1.2 trillion, or roughly 4% of the total universe. They also fall under 23 different ETF categories. You can build a high-yield diversified portfolio from them. Overall, we find that a 5% yield can actually be found in more than 25% of categories.

It’s important to look at deriving income from both equities and fixed income, both for diversification and—yes—to get a little extra bang for your bucks. Here are some of the top contenders:

  • High-Yield Bonds. This category is most prominent, with five ETFs yielding over 5%, representing over $27 billion, more than 50% of the assets. The largest ETF in this space is the iShares iBoxx $ High Yield Corp Bond (HYG) with $14 billion—over 28% of the assets in this group.
     
  • Miscellaneous Sector. This was the second largest category, with four preferred-stock strategy ETFs.
     
  • Sector-focused strategies. Communications, real estate, industrials and energy were all represented. Many of the companies in these sectors pay out a high level of their net income in dividends rather than reinvest the cash in their companies.

Keep in mind, mixing bond and stock strategies can moderate portfolio risk. An all-bond portfolio is not the lowest-risk portfolio. A too-conservative portfolio can be risky as it may not keep pace with inflation. Focusing on income alone will also not protect you from the potential loss of capital. You’re giving up some potential growth for recurring stream of income as some companies are paying out dividends rather than reinvesting to promote corporate growth.

Each of these strategies has its own set of risks and needs to be considered carefully for appropriateness for each investor. If interest rates rise, and they eventually will, an all-bond portfolio will suffer. While adding bonds for a yield boost is a common strategy, diversifying the sources of income and the risks associated with them can help mitigate overall portfolio risk.

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