3 Must-Own High-Yield ETFs

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Includes: BDCS, JNK, PFF
by: Larry Meyers

Summary

High yields are easy to find in ETFs.

These choices are highly diversified, offering a good deal of safety.

High yields can be found in equities, preferred issuances, and bonds.

The explosion of ETFs, especially high-yield ETFs, in the stock market has provided investors with one of the best routes ever to create a diversified portfolio. ETFs offer instant diversification, and that spreading of risk creates a higher degree of safety. You could hold nothing but ETFs in your portfolio and be well-diversified for the long term, and have every sector covered.

High-yield ETFs are particularly attractive, especially to retirement investors. In retirement, one's appetite for risk declines substantially while the need for income increases. High-yield ETFs provide the decreased risk while also paying out the income required.

The trick for high-yield investors has been how and when to chase yield. Attractive high yields have been tougher to obtain, as bond investors have flooded the dividend market, thanks to the Fed's quantitative easing program, which pressured bond yields. Going further out on the risk curve is not what most retirement investors seek.

Fortunately, there are high-yield ETFs that fit the bill.

UBS E-TRACS Wells Fargo Bus Dev Comp ETN (NYSEARCA:BDCS) is a great high-yield ETF selection. The fund invests in a basket of Business Development Companies that throw off big dividends. BDCs are a particularly attractive investment for dividend hunters. These are companies that borrow funds at low interest rates, or raise money via equity, and then invest it in rapidly-growing companies in the 'middle market'.

The middle market represents companies that have established solid cash flow and a viable business, but need more cash to fund rapid growth. They may have exhausted bank credit lines already, or banks view them as having too much risk. BDCs step in and fill the gap. They will take on senior or subordinated debt and earn from 11 - 17% on the investment, as well as take a small equity position in the company.

The risk is that a BDC will make one or more very poor investment choices and lose a lot of money.

On the other hand, many BDCs also take warrants to buy an equity position in the companies they lend to. That creates the potential for significant upside. Thus, one not only has the opportunity for a nice coupon, but to share in capital gains if the company should IPO.

BDCs are required under law to pay out 90% of their net income, just like REITs do. Most of these distributions occur quarterly, and many can run over 10% annually.

BDCS is great because while any given BDC may implode as a result of bad investment decisions, it's unlikely a basket of them will. Thus, the diversification provides a degree of safety, along with a 7.29% yield.

BDCS has 32 components, of which the top 7 take up some 56% of the portfolio. I'd prefer more equal-weighting than cap-weighted, but there is sufficient diversification here.

  • 10.3% American Capital (NASDAQ:ACAS)
  • 9.96% Ares Capital Corp (NASDAQ:ARCC)
  • 9.73% Prospect Capital Corp (NASDAQ:PSEC)
  • 9.12% Apollo Investment Corp (NASDAQ:AINV)
  • 6.82% Fifth Street Finance Corp (FSC)
  • 5.38% Main Street Capital Corp (NYSE:MAIN)
  • 4.68% Solar Capital Ltd (NASDAQ:SLRC)

The ETN trades at $25.58, off its 52-week high of $29.81, and closer to the 52-week low of $24.22. It has a 3-year historical return of 27.15%, just slightly ahead of the S&P 500's 20.47% return. However, with a beta of 0.83, it comes with 17% less volatility than the market.

iShares U.S. Preferred Stock (NYSEARCA:PFF) invests in a large basket of preferred stocks. Preferreds are attractive because they have qualities of both bonds and stocks. They trade as stocks, yet holders of preferreds are in front of common stockholders to collect back their principal if the company goes bankrupt. The trading ranges, however, are very akin to bonds. They tend to stay in a fairly tight range.

In addition, if the company has to suspend dividends, it must suspend common dividends before preferred dividends.

Companies that are financially solid will often have preferred shares that offer high yields. The idea of preferred stock is that it allows a company to raise capital without diluting current shareholders and without subordinating current creditors.

The PFF basket TTM yield is an impressive 6.68%, with a distribution yield of 5.78%, and PFF holds many world-class financial stocks that are unlikely to experience trouble.

What's wonderful about this ETF is it has a whopping 327 holdings, giving you tremendous diversification. The top three holdings only account for 6.9% of the total index.

These include preferred shares of Barclays (NYSE:BCS), Wells Fargo (NYSE:WFC), Citigroup (NYSE:C) and Bank of America (NYSE:BAC).

There is also geographical diversification. 75% of the holdings come from the U.S., but 14.89% come from the U.K., 5% from the Netherlands, 2.12% from Bermuda, and 1.25% from Luxembourg.

The ETF has provided a five-year average annual return of 11.8%. and 74.7% cumulative. That trails the 91% cumulative return of the S&P 500, but does so with a beta of only 0.84.

SPDR Barclays High Yield Bond (NYSEARCA:JNK) invests in a basket of junk bonds, but don't let the word "junk" fool you. It doesn't imply bonds that are going to default, but bonds that are not rated as highly as others. In order for a company to default on a bond payment, it must be in big trouble as a going concern.

If enough questions surround the viability of the company that when it issues debt, it must pay higher interest rates. That means higher yields for bond investors, and ETFs that invest in high-yield instruments.

The ETF holds 728 securities, and the largest holding only represents 0.77% of the fund. So any individual implosion is not going to take down the entire ETF.

The top ten holdings only amount to 5.2%, and have familiar names like bonds from Sprint (NYSE:S), First Data, and HCA (NYSE:HCA).

The average bond's maturity is 6.62 years, so it isn't as far out as the 10-year Treasury benchmark of most bonds. The average yield to worst is 5.5%, while the current yield is 6.63%, and the dividend yield comes in at 5.78% -- which is the number most investors care about.

Interestingly, the fund has a 5-year annualized return of 11.43%, which isn't too different from PFF, but comes with a slightly higher beta of 0.90.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.