With interest rates continuing to hover near record lows, investors accustomed to generating attractive current returns from high quality fixed income securities have been forced to get creative in their quest for yield. The prolonged period of low rates has posed problems for those who rely on their portfolio to generate proceeds to cover living expenses, as payouts on Treasuries have sunk. High quality corporate debt isn’t much more attractive, as companies have issued debt this year in record amounts in order to take advantage of extremely favorable borrowing terms.
Google (GOOG) recently issued $3 billion of debt at just 1.25% for one-year notes and 2.125% for three-year notes, while Johnson & Johnson (JNJ) recently issued $3.75 billion that included two-year notes paying the lowest interest rate for bonds of that maturity in records extending to 1999, according to Bloomberg.
Approaches to beefing up yields have varied widely. Some have gravitated toward dividend-paying stocks, with many embracing a slew of ETFs that use various strategies to tap this corner of the equity market. Others have turned toward securities such as MLPs or BDCs that generally pay out attractive distributions in order to maintain favorable tax status.
Turning Toward Dividends
Dividend or yield investing has become increasingly popular over the years, as investors have seen the extreme benefits that this strategy offers. Dividend-paying stocks can make for effective inflation hedges, as yield payouts tend to rise in inflationary environments, providing some hedge against rising prices. Yields also somewhat protect against bear markets, helping to cut investment losses with steady income payouts through out the year.
At first glance, it can be easy to overlook dividend yields when making investment decisions. For example, seeing a 2% yield on a fund may seem minuscule, but consider this: A portfolio with a baseline investment of $100,000, earning an average 2% annually off of dividends will appreciate to approximately $122,000 in 10 years, and nearly $150,000 in 20 years, assuming the gains are re-invested and no appreciation in stock price. In fact, a recent study conducted by Standard & Poor’s revealed that dividend components were responsible for 44% of the total return in the last 80 years of the S&P 500′s history. From 1950 until 2010, an investment of one dollar with dividends and reinvestment would have performed eight times better than a dollar invested in a non-dividend fund; that dividend invested dollar would be worth roughly $500 today.
There are a number of ETFs designed to focus on dividend paying stocks, from the suite of WisdomTree funds linked to dividend-weighted indexes to ETFs such as the Vanguard Dividend Appreciation ETF (VIG) and SPDR S&P Dividend ETF (SDY).
MLPs and BDCs: Off the Beaten Path
There are other types of securities that have track records of paying out hefty distributions, including Master Limited Partnerships and Business Development Companies (BDCs). Both of these types of entities maintain certain tax advantages if they pay out certain percentages of their income, resulting in stable and meaningful distributions.
There are a number of ETPs offering exposure to MLPs, including both ETFs and ETNs. In addition to the traditional trade off between tracking error and credit risk, the decision of which vehicle to utilize can have meaningful tax consequences, and potentially result in very different realized returns. For accessing BDCs, the ETP options are more limited. The recently-launched E-TRACS Wells Fargo Business Development Company ETN (BDCS) is the best pure play option available.
High Yielding Bond ETFs
Though tracking down a decent yield from fixed income securities has become more challenging in the current environment, it certainly isn’t impossible. Investors willing to take on a bit of additional risk have plenty of opportunities, including several outside the umbrella of traditional junk bonds. Of course, with the potential for meaningful current returns comes significant risk: High-yielding fixed income securities often exhibit higher chances of default than investment grade debt, and many may exhibit volatility more characteristic of equities. Below, we outline three high-yielding bond options in the current environment.
CEF Income Composite Portfolio (PCEF)
This product follows the S-Network Composite Closed-End Fund Index, which is a rules-based index intended to give investors a means of tracking the overall performance of a global universe of U.S.-listed closed-end funds. PCEF is somewhat unique: An open-ended ETF that invests in closed-ended funds, and offers an extremely attractive current return thanks in part to a methodology that focuses on funds trading at significant discounts to NAV. With debts maturing all across the board, this fund is sporting a 30 SEC yield in the neighborhood of 8.6%. That return has come historically with minimal volatility, upon closer inspection of this product’s chart, PCEF has spent the better part of a year within a small price range.
Market Vectors High Yield Municipal Index ETF (HYD)
HYD invests in an index which has a 25% weighting in investment-grade triple-B bonds and 75% weighting in non-investment grade bonds. This product has just over 100 total holdings, the vast majority of which are unrated or junk bonds. While this makes the product somewhat risky, it results in a yield profile that may be very attractive for investors in a high tax bracket who are seeking to generate meaningful current returns. The 30-Day SEC yield for HYD is about 6.1%, which translates into a tax-equivalent yield of about 8.1% for those in the 25% bracket and a yield of close to 9.4% for those in a 35% bracket.
Peritus High Yield ETF (HYLD)
HYLD offers a unique exposure not seen anywhere else in the ETF space: Fixed income exposure through an actively-managed exchange traded product. Though HYLD has a relatively short operating history, its performance suggests that the high yield debt market may be one where an experienced management team is capable of generating alpha relative to passive, cap-weighted benchmarks. This fund is currently yielding 7.5%, and has gained nearly 5% in 2011 - better than any other fund in the High Yield Bonds ETFdb Category by a wide margin. HYLD is a bit pricey compared to the expense ratios charged by many passively-indexed products, but its performance in recent months has more than justified the charges.
Disclosure: No positions at time of writing.
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