September 20, 2013

4 High-Yield ETFs in a QE World

Schwab’s Iachini joins SSgA’s Keller in identifying fixed-income ETF opportunities — for investors who are willing to take on risk

When the Federal Reserve’s policymakers surprised investors and postponed their plans to taper bond purchases, both the stock and bond markets rallied on Wednesday. But now that the dust is settling, fixed income exchange traded fund flows have gone back to what they’ve been doing since early May: trending toward opportunities in yield-producing ETFs.

In a media conference call on Friday, Michael Iachini, Schwab’s managing director of ETF research, joined John Keller, State Street Global Advisors’ (SSgA) vice president of global cash and fixed income investment management, to identify where those opportunities might lie.

The focus of their call was on how ETFs are holding up in the rising interest rate environment, and the factors that investors should consider when looking for yield in bond ETFs. To be sure, both Iachini and Keller spoke of the risks implicit in high-yield bond ETFs, but they also asserted that yield has a key role to play in a broader allocation strategy.

“Obviously, the Fed’s statement surprised most of the market,” said Keller, whose firm is a partner on Schwab’s ETF OneSource commission-free platform. He noted that he saw one report showing institutional expectations were 99% that the Fed would announce a start to tapering.

While SSgA expects the Fed to begin tapering in mid-2014, rates are still low, and if not at all-time lows, then at historically low levels, Keller added. “Investors have to think of portfolio duration,” he said. “What investors need to think about is not that the Fed surprised the market, but that they need to make sure to think about the overall composition of their portfolios.”

In light of the bond market’s current low-yield conditions, Schwab’s managing director of ETF research, Michael Iachini, has identified four income-generating strategies for investors to consider:

1) High-yield bond funds. “A lot of investors are eager to jump into ETFs that pay a lot of income,” even though the underlying bonds are issued by by less creditworthy companies, Iachini said during a media call on Friday that also featured State Street Global Advisors’ John Keller.

Investor, be warned: “Typically, if you’re receiving good income from an ETF, there’s a catch: increased risk,” Iachini said. He observed that high-yield bonds — also known as “junk” — carry a default risk, and they move in tandem with the stock market.

ETFguide Chief Market Strategist Chad Karnes seconds Iachini’s observation in a comment published Thursday: “If there is one investment category that does belong in the same discussion as ‘highly correlated’ with equities, it is junk bonds,” Karnes writes. “These types of high-risk bonds behave and act more like equities than any other bond class.”

2) Bank loan ETFs. Again, Iachini said, short-term bank loan ETFs are debt issued by companies that are less creditworthy, so these investments are subject to default risk.

Yet Morningstar found that while advisors’ interest in fixed income funds has slackened since 2012, bank loan strategies were featured on both its top mutual funds and top ETFs lists this year.

“What we’re seeing in fixed incom at State Street’s SPDR family of funds is a lot of flows into the sectors that Michael mentioned,” Keller said. “We’re seeing outflows from broader maturity ETFs and inflows to shorter duration ETFs.”

3) Mortgage REIT ETFs. These instruments have the advantage of being pegged to an index rather than mortgage bonds.

However, according to IndexUniverse’s Cinthia Murphy, since the beginning of the year, mortgage REIT ETFs have had a tough time getting off the ground, as the companies they hold face declining book value amid rising interest rates.

“The higher-rate environment — 10-year Treasury note yields have jumped nearly 100 basis points so far this year — has hurt the mortgages that are on the books of these REITs because, at least in theory, the book value of REITs is inversely correlated to interest rates,” Murphy wrote on Aug. 13.

4) Closed-end funds. CEFs can buy a variety of assets, and they are currently popular as a higher-yielding instrument, Iachini said.

Investors in June got a new ETF that seeks to provide income by investing in a basket of closed-end funds, ETFtrends reported on June 19: “Exchange Traded Concepts LLC in conjunction with YieldShares LLC earlier this year filed a registration statement, including a preliminary prospectus, for the YieldShares High Income ETF (YYY).”

The risk? CEFs use leverage to amplify income, but risk increases when the bond market falls, and they can trade “at a disconnected value to assets,” Iachini said.

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