For long-haul ETF investors, the financial landscape has changed considerably over the past several years, largely due to a hunger for income solutions. "There's an increasing need for income, and that's not going away, especially with more and more people retiring," says Morningstar fund analyst Michael Rawson.
Income was also a hot topic at the recent Morningstar ETF Invest Conference. "Income is paramount, but income is scarce right now because interest rates are so low," Ben Johnson, a Morningstar director of fund research, says in a video on the firm's website. "In the ETF space, what you see is product proliferation. People are searching high, low and everywhere in between for income."
ETF providers have put out a slew of new bank-loan products over the past few years aimed at generating higher income than other debt instruments. Bank-loan ETFs "provide floating rates [that] are higher than that provided by T-bills, but contain a measure of credit risk," Rawson says. Among these products: PowerShares Senior Loan Portfolio (BKLN), Highland/iBoxx Senior Loan (SNLN) and SPDR Blackstone/GSO Senior Loan (SRLN), which kicked off in April. The oldest in the group, BKLN, listed in March 2011 and has $5.85 billion of assets, and has generated a 12-month yield of 4.64%.
Set at a specific level above LIBOR, bank-loan ETFs reset every three months in conjunction with LIBOR. While bank loans are secured by collateral such as real estate, equipment and receivables, Rawson says they carry risk that extends beyond credit concerns.
"People are embracing the credit risk aspect because the economy is generally strong," he says. "This seems an ideal trade-off between wanting to avoid interest rate risk, but not wanting to take as much risk as you would get in the equity markets." He cautions, though that "if there are massive flows into this category, you could see dislocation with price and fair value."
Other new offerings in the income segment include UBS ETRACS Diversified High Income (DVHI). This new exchange-traded note aims to offer a new way to target high-yield securities from around the globe in a variety of segments. It follows the NYSE Diversified High Income Index - which follows the performance of a basket of 138 securities that have historically paid high dividends or distributions - and charges investors 84 basis points a year. As of mid-October, the index's yield was 7.7%.
Rawson points to preferred stock ETFs as another source of relatively high income yields. Preferred instruments have gained in popularity while rates have been low, partly due to their combination of bond and equity characteristics. "These are income-oriented vehicles with less market risk than [other] equities," he says. The largest of these ETFs, iShares S&P U.S. Preferred Stock (PFF), manages more than $9 billion and invests in more than 300 securities, mainly from the diversified financials, banks and real estate sectors. As of mid-October, the 12-month yield on PFF was 5.66%; its expense ratio is 0.48%.
Like bonds, preferreds generally pay stable dividends with more frequent distributions than common shares. Among the risks: Preferreds can be called by the issuing company. Also, these stocks are convertible.
With these funds, what matters as much as the yield, Rawson says, is "the true cost of owning an ETF based on the ETF's holding costs, the ability of the ETF to track the index performance, tracking volatility and market impact cost."
Laton McCartney is a New York writer who has contributed to Money Management Executive and Information Management.
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