A Private Matter: Income ETFs (HDV, LQD and OEF)

Includes: HDV, LQD, OEF
by: Kevin Feldman

Last week a colleague asked me if, given all the focus on investing for income this year, the “i” in iShares might come to stand for income. He was kidding, but he had a serious point too: With government bonds generating historically low yields - the 10-year Treasury broke through 2% not long ago - many investors are understandably searching for higher yields in the private sector.

Like Russ Koesterich, I generally favor a focus on total return. But I recognize that there are a lot of people who prefer to preserve principal and invest for income in order to draw on that income in retirement. With those income-seeking investors in mind, I want to discuss three income iShares ETFs: S&P 100 (NYSEARCA:OEF), High Dividend Equity (NYSEARCA:HDV) and an intermediate corporate bond ETF (NYSEARCA:LQD).

Why include a fixed income ETF in a blog about equity income investments? Two reasons. First, LQD provides an opportunity to compare after-tax returns on qualified and non-qualified income. Second, it’s important to understand how equity and fixed income ETFs (through their underlying holdings) will likely react differently within portfolios in terms of risk and correlation with other investments.

From an income perspective, qualified dividend income (QDI) has some distinct tax advantages. The 30-day SEC yields on HDV and LQD have been almost identical at 3.90% and 3.87%, respectively, as of Aug. 15, almost double the current 10-year Treasury yield. (Past performance does not guarantee future results. For standardized fund performance, click on these tickers for HDV and LQD, respectively.) Yet the HDV yields are considered qualified dividends, which are currently taxed at 15% (or 0% if your income is in the bottom two tax brackets), while LQD yields are taxed at regular income rates.*

If HDV has tax advantages over LQD, LQD has an advantage of its own: With its investment-grade bond focus, its THREE-month correlation with the S&P 500 Index as of the end of July was negative 0.24. Like most bond ETFs, LQD tends to move in the opposite direction from equity markets. HDV, however, has had a positive 0.88 correlation with the S&P 500 Index over the same period. (Yes, this is a short time frame over which to evaluate correlations, but HDV’s inception date was only March 29 of this year.)

This is an important point, so I want to reinforce it: HDV has provided some shelter from equity market volatility, but not nearly as much as LQD.

And what about the S&P 100 ETF (OEF)? Though its 30-Day SEC yield as of July 29 is only at 2%, OEF could still be a good option here. (Past performance does not guarantee future results. For standardized fund performance for OEF, please click here.) I like that it includes both growth and value mega-cap companies (Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL), for example). There’s also a compelling relative value rationale for adding OEF now, as Russ K explains. Finally, OEF includes many securities with qualified dividends, so on an after-tax basis, a 2% dividend could generate more after-tax income compared to earning 2% in a taxable bond if your income is above the bottom two tax brackets.

As with all things in investing, there’s no free lunch in higher yields. Seeking higher returns means taking on higher levels of risk. Depending on your goals, time horizon and view of the macro economy, you may choose to take those risks but it’s important - even given the understandable desire to generate income during a challenging market - not to forget that they’re there.

Disclosure: Author is long OEF.

* The Jobs and Growth Tax Relief Reconciliation Act of 2003, as extended, reduces tax rates on “qualified dividend income” (QDI) from common stock, certain preferred stock, and certain qualified foreign corporation stock subject to holding period and other requirements. Interest from bonds and other fixed-income instruments is not treated as qualifying income. Regulated Investment Companies, such as iShares ETFs, may designate the eligible portion of their dividends paid as QDI. The QDI portion of a fund’s dividends is reported in Box 1b of Form 1099-DIV.

Fund holdings are subject to change.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. There is no guarantee that dividends will be paid. Bonds and bond funds will decrease in value as interest rates rise.

This material is not intended to be tax advice. Tax consequences may vary by individual taxpayer. Please consult your tax professional for more information with regard to your specific situation