Investors might be tempted to go after high yield ETFs without understanding the risks.
Taxes can complicate certain ETFs.
Be smart about finding income from your investments; don't just take the highest yield.
In today's low-interest-rate environment, it is becoming increasingly difficult for investors to find good yields. Although it can be tempting to jump into an exchange-traded fund (ETF) that pays a lot of income without really understanding how it works, investors should resist this temptation because some of the more aggressive income-generating strategies can be complicated and risky.
High yield bonds: High risk bonds
When you see the words "high yield," mentally substitute "risk" for "yield" since you usually don't generate more income without taking on more risk.
For example, let's look at high yield bonds. These bonds are issued by less-creditworthy companies that carry a higher risk of default than better-rated issuers. High yield bonds tend to move more closely with the stock market. Therefore, if the stock market falls, the market value of a high yield bond is more likely to fall than the market value of a bond with higher credit quality.
High yield bonds were affected more than stocks by the credit crisis of 2008.
The blue line on the chart above shows the level of the S&P 500® Index from 2007 through mid 2009. The purple line shows the Markit iBoxx USD Liquid High Yield Index, which is tracked by a large high yield bond ETF. As you can see, the high yield index fell even farther than the stock index during the credit crisis of 2008 before rebounding in 2009. (Source: Bloomberg)
This doesn't mean you should completely avoid high yield bonds. Investing in them via an ETF provides some diversification benefits compared to buying a single high yield bond, but understand that these bonds are issued by companies whose ability to repay debt is questionable.
Master Limited Partnerships (MLPs): After-tax ETF returns
MLPs are among the most complicated investments available in ETFs today. These partnerships typically own interests in oil and gas transportation, and historically have paid relatively high amounts of income compared to most stocks.
If you own shares (or "units") of an MLP directly, you can expect some tax advantages. MLPs held directly make some distributions that are counted as a return of capital, meaning that they're not taxable.
However, MLPs come with some tax complications as well. Instead of a 1099 form, your share of partnership income and expenses are reported on a form K-1, which tends to be more complicated to deal with when completing your taxes. Some investors worry about K-1 tax forms because they might arrive late or may incur Unrelated Business Taxable Income (UBTI) that could be taxable even within an IRA.
Many investors turn to an ETF that owns MLPs instead of owning the MLPs directly. MLP ETFs are generally structured as C corporations. Any cash that these ETFs distribute to shareholders will be treated as stock dividends and reported on the standard 1099 form.
Now, here's the catch. Normally, most ETFs and mutual funds pass along gains to their shareholders without paying taxes first themselves. In contrast, most MLP ETFs file their own income tax returns and pay taxes before they pay out any distributions. Thus, MLP ETF investors are getting after-tax returns and are still obligated to pay dividend taxes on distributions from the ETF. Although it's a simpler tax treatment than a K-1, the returns are generally lower than the returns of holding the basket of MLPs directly.
Bank loans: Short-term, but with credit risk
Bank loan ETFs (sometimes referred to as senior loan ETFs) may provide some protection against rising interest rates. Bank loans tend to have short duration and interest rates that reset periodically (either monthly or quarterly). Some investors see the short duration and assume that these funds must have less risk. After all, short-term debt is less vulnerable to losing value if interest rates rise.
But remember that higher yield comes with higher risk. Bank loans, whose risks flow through to the ETFs that own them, are debt issued by companies that are typically less creditworthy. These investments are still subject to credit risk, just like high yield bonds, even if these loans are typically backed by collateral.
Mortgage REITs: Leverage risk
REITs are real estate investment trusts. Most investors have heard of "equity REITs," which own actual real estate. However, mortgage REITs have been receiving more attention from income-focused investors.
Instead of buying actual property and buildings, mortgage REITs buy mortgages, collecting interest. What's more, these REITs typically use leverage (borrowed money) to buy mortgages, which amplifies their positive and negative return potential.
ETFs that own mortgage REITs tend to have attractive yields because of the leverage that these REITs use. However, if the value of the mortgages falls, such as in a rising interest rate environment or a housing crisis, these ETFs could quickly lose value.
Closed-end fund ETFs: Leverage again
Some ETFs buy shares of other funds, like closed-end funds (CEFs). CEFs can buy a variety of assets, but many invest in bonds that pay interest.
As with mortgage REITs, closed-end funds are permitted to use leverage, and many do. This can amplify their income, but at the cost of increased risk when the bond market falls. Furthermore, closed-end funds can (and often do) trade at prices that are disconnected from the underlying value of their investments. This can further magnify losses in a falling market. CEFs also tend to sell at discounts when everyone wants out, which is even worse for shareholders.
Understand the risks
If you're getting more income from an investment, there's usually a catch in the form of more risk. This doesn't mean that you should avoid risk completely, but be smart and understand the risks you're taking if you choose to chase after yield. Be careful out there!