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How to earn up to 7% in ETFs

ETFs and income? Yes, there are products offering decent yield – and potential growth as well. We found six worth considering.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 10/09/2012
  • Investing Strategies
  • Investing in Bonds
  • Investing in ETFs
  • Exchange-Traded Funds
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Exchange-traded funds have grown popular because they offer cheap and easy ways to invest in everything from Australian copper mines to Brazilian banks. A lesser-known feature of ETFs is that you can use them to generate income, though it does take some legwork to find ones with attractive yields that don't take excessive risk.

ETFs are like mutual funds that track an index and trade on a stock exchange, and more than two dozen ETFs now yield 7% or more. But many of those invest in currencies or other highly volatile assets. The WisdomTree Dreyfus Brazilian Real Fund (BZF), for instance, has a distribution yield of a 30.2% – but in total, the ETF lost 16.1% in the last year as the Brazilian real slid against the dollar.

Other ETFs use leverage or derivatives to inflate returns – risky strategies that can backfire in a hurry.

If you do want to use ETFs to generate income, keep an eye on total returns, not just yield, says R. Alan Dossett, a financial adviser with Waypoint Financial Planning in Southborough, Mass. Whatever the ETF invests in should be reasonably priced, with good prospects for growth, he says, adding one more caution: Investors should steer clear of yields that seem too good to be true.

If you decide to use ETFs as part of your income strategy, there are ways to manage risk.

  • As with any investment, know what you own. Make sure you understand what the ETF invests in and how risky the underlying assets are.
  • Diversify. Buying a basket of several income ETFs that aren't highly correlated can help lower risk. For example, U.S. municipal bonds and foreign stocks usually don't move in tandem, and holding them in a portfolio with other investments can smooth out returns.
  • Check how the ETFs mesh with your total holdings. If you're considering an ETF that invests in junk bonds, for example, make sure it doesn't raise your overall bond risk; you might add a shorter-term bond fund or one that invests in investment-grade debt to balance your exposure.

With these caveats in mind, here are five ETFs that yield 4% to 7% and one that yields north of 12%. While most ETFs have transaction fees, advisers recommend buying ETFs gradually over time to lower your average cost.

Lastly, it's always a good idea to consider the tax man before investing. ETFs that generate lots of taxable income work best in tax-advantaged accounts such as IRAs. Income and capital gains grow tax-free in these accounts, which can be especially useful for high-yield corporate bond ETFs whose distributions are taxed as ordinary income at rates up to 35%.

PIMCO 0-5 Year High Yield Corporate Bond Index Fund

  • Ticker: HYS
  • 30-Day SEC Yield: 4.2%
  • Expense Ratio: 0.55% 

A 4% yield may seem like peanuts in a junk bond fund but this ETF takes less risk than most rivals in the space. It holds bonds that mature in five years or less, and these shorter-duration bonds are less sensitive to rising interest rates than debt with longer duration. Plus, they usually trade at cheaper prices, according to Morningstar analyst Samuel Lee.

Most junk-bond ETFs automatically kick out bonds once they mature in a year. That depresses prices and creates more bargains among these bonds.

While the ETF tracks an index, PIMCO uses a somewhat active approach: buying bonds opportunistically and using other types of securities to maintain the ETF's liquidity and yield. The ETF avoids bonds that PIMCO analysts flag as bad bets, says Lee, and the manager "doesn't slavishly follow the index."

One drawback to this ETF is that its fees are on the high side and it's likely to underperform if there's a sharp rally in junk bonds. Still, returns for short-term junk bonds historically average 9.6% a year versus 8.8% for the broader junk bond market, and short-term bonds are less volatile, according to Morningstar.

That combination could offer a more appealing mix of risk and reward for many income investors.

SPDR Nuveen S&P High Yield Municipal Bond ETF

  • Ticker: HYMB
  • 3-Day SEC Yield: 4.5%
  • Expense Ratio: 0.45%

High-yield muni bonds are known as junk for good reason. They garner the lowest credit ratings in the muni-bond universe, and they're more volatile than your average muni fund. Still, yields on these investments can be attractive if you're willing to take on a bit of extra risk.

For example, in a taxable account it's tough to beat this fund's yield of 4.5%. The tax-equivalent yield for investors in the 35% federal tax bracket is 6.9%, according to the ETF's sponsor, State Street Global Advisors. That beats high-yield corporate debt. And only 10.3% of the ETF's income is subject to the alternative minimum tax, making it a good option for investors in high tax brackets.

One plus for this type of fund is that muni-bond defaults are extremely rare. Still, the market is likely to take a hit if expectations for defaults rise, says Morningstar bond analyst Timothy Strauts.

A bigger pain point for this fund, though, could be its sensitivity to rising interest rates. The average duration of the fund's bond holdings is 10 years and if the ETF's yield rises 1%, the share price would lose about 10%. "A strong rise in rates will destroy this fund," says Strauts.

One way to lower that risk is to add a shorter-duration muni ETF such as the iShares S&P National AMT-Free Municipal Bond Fund (MUB). Its tax-equivalent yield is just 2.7%, but it's less rate-sensitive with a duration of 6.2 years, meaning it would lose around 6.2% if the yield rises 1%.

On the positive side, the SPDR Nuveen ETF is well diversified with over 175 holdings across dozens of states and municipalities. Demand for muni-bond income has been strong this year. And if Washington hikes taxes in 2013 — which looks increasingly likely — money may pour into tax-free munis, lifting prices further.

PowerShares Senior Loan Portfolio

  • Ticker: BKLN
  • 30-Day Yield: 5%
  • Expense Ratio: 0.76%

This ETF invests in bank loans, which are the loans private equity firms often take out to finance a leveraged buyout, pledging corporate assets as collateral against the loans.

Some companies also use these "senior leveraged loans" to finance operations, often with floating interest rates that adjust every 30 to 90 days. That makes them a good bet when rates rise, since their interest payments increase as well. And the loan market has fared well with the ETF returning 14% in the last year, including a 12-month trailing yield of 4.9%.

Bank loans aren't nearly as safe as investment-grade corporate bonds and they can be volatile; the market plunged 29% in 2008 and would take a big hit if the economy nosedives. Still, the 12-month default rate on bank loans is low at around 1%.

In addition, bank loans are considered more secure than junk bonds since the loans are secured by a company's assets — ensuring that investors get paid first in the event of a default or restructuring. And with investors pouring money into higher-yielding investments, the market may continue to rise, says Morningstar analyst Strauts. "Leveraged loans are a slightly safer way to play the high-yield space," he says.

PowerShares Preferred Portfolio

  • Ticker: PGX
  • 30-Day SEC Yield: 6.4%
  • Expense Ratio: 0.5%

Preferred shares generate steady income like bonds but have stock-like characteristics, giving investors an ownership stake in a company. Preferred shares issued by banks and other financial companies account for more than 90% of this ETF, making it in effect a bet on the cash flows of the financial industry.

With many banks and financial companies reporting stronger earnings and improving their balance sheets, default risks have come down, and the ETF has a higher average credit rating than some other preferred ETFs, making it a good option, says financial adviser Matt Reiner of Capital Investment Advisors in Atlanta.

Right now preferred shares aren't cheap, trading at a premium to historical averages. With a 13.3% return so far this year, the ETF isn't likely to post another year of double-digit returns in 2013, and preferred stock prices can tumble when interest rates rise sharply. Still, the ETF's 6.4% yield beats most bonds, and it generates a decent income stream, says Reiner, who recommends the ETF for about 5% of his clients' portfolios.

SPDR S&P International Dividend ETF

  • Ticker: DWX
  • 30-Day SEC Yield: 6.8%
  • Expense Ratio: 0.45%

This ETF tracks an index of high-yielding foreign stocks with at least three years of earnings growth, and it looks cheap, trading at a 40% discount to the S&P 500 (.SPX) based on the one-year forward price/earnings ratio.

Companies in the ETF are growing earnings at a 6% estimated rate, according to State Street Global Advisors, the ETF's sponsor. And the ETF could get a lift if the U.S. dollar weakens from its recent highs, says financial adviser David Blain of New Bern, N.C., who uses the ETF for clients.

One thing that could sink this ETF is another flare-up in Europe. More than 60% of the ETF is in European stocks — mainly telecoms, financials and utilities — which would likely sell off if the debt crisis worsens.

Yet many businesses in the ETF generate a significant share of sales outside Europe. The ETF's top holding, for instance, is ACS Group, a Spanish construction company that gets 39% of sales in Asia/Pacific markets and 31% in North America. Revenues have been rising and operating income jumped 28% in the first half of 2012, according to the company.

"It's not like these companies are all going backwards," says Blain, and they yield much more than U.S. stocks.

iShares FTSE NAREIT Mortgage Plus Capped Index Fund

  • Ticker: REM
  • 30-Day SEC Yield: 12.3%
  • Expense Ratio: 0.48%

Real estate investment trusts that buy mortgage-backed bonds are enjoying a booming business. Thanks to the Fed's easy money policies, they're able to borrow money at near zero percent and use the proceeds to buy government-agency mortgage bonds yielding more than 3% — earning a tidy profit off the "spread" in rates. These mortgage REITs make up 97% of this ETF, which has gained 29% this year, trouncing the S&P 500 and most other fixed-income investments.

Whether there's much juice left in mortgage REITs is debatable, and it's a risky area of the market.

The Fed's new program of mortgage-bond buying could push down mortgage rates. That could force mortgage REITs to cut dividends as their interest income get squeezed. Indeed, the ETF's top holding, Annaly Capital (NLY), cut its third-quarter dividend to $0.50 per share from $0.55 in the second quarter, and analysts expect more dividend cuts ahead.

With the housing market recovering, though, the ETF may still have upside. Mortgage bonds may continue to rally as home prices rebound and loan default rates come down. Plus, the ETF's 12% yield provides an ample cushion against losses, notes Reiner, who recommends the ETF for his clients.

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