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Junk Bonds, Preferred Stocks, REITs: Why Investors Should Consider High-Yield ETFs

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Soaring interest rates have made a significant impact on these high yield funds, but opportunities are still abundant.

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In the world of high-yield ETFs there are four main categories: junk bonds, preferred stocks, mortgage REITs, and master limited partnerships. Each of these sectors offers their own unique opportunities and risks when it comes to generating dividends for shareholders. The last three months of soaring interest rates have thrown many high yield investors for a loop and left them wondering whether to buy, sell, or hold their favorite dividend powerhouses. By analyzing each of these asset classes we can determine which are healthy and which may need more time to stabilize.

Without a doubt, the sector that has been hit the hardest by this interest rate ramp has been mortgage REITs. In fact the iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) has fallen over 20% from high to low in 2013. This ETF holds nearly $1 billion in 33 specialized financial stocks which invest directly in mortgage-related debt and use excessive leverage and hedging strategies to juice their returns. Mortgage REITs have thrived in a world of zero interest rates because they are able to borrow short-term money very cheap and use it to buy long-term debt. This enables them to pocket the spread on interest rates and distribute the majority of earnings to shareholders.

One of the benefits of owning REM is its double-digit yield, which currently stands at 13.77% according to iShares.com. However, it is important to realize that if credit begins to tighten, the borrowing costs of these REITs will also increase, which may hinder their ability to sustain these fantastic yields. Whenever I see a double-digit yield, I am always reminded of the phrase "high yield = high risk," which is why I am avoiding this sector at this time. Short-term traders that want to take advantage of volatility may consider a small allocation, however I would recommend that you do so with a tight stop loss to guard against further downside risk.

Speaking of downside, both the preferred stocks and high yield bond sectors of the market have experienced their first signs of real volatility in May and June. Prior to this most recent sell-off, income investors have been capturing 5-6% yields in these sectors with steady capital appreciation and very minimal price swings. This has led to what many experts have feared to be a bubble in high-yield bonds, which is a direct result of investors having to take greater risks with their capital to generate the level of income they need to survive.

Both the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) and the iShares US Preferred Stock ETF (NYSEARCA:PFF) have fallen over 5% from their highs and now sit in negative territory for the year. In addition, both of these ETFs are just slightly below their 200-day moving averages. I scaled back on my exposure to these high-yield funds several months ago and am considering entering new positions at lower price levels. Now that they have worked off some of their overbought momentum, the valuations and yields are looking more attractive. The one caveat is the potential for additional downside in the stock market over the next several months, which would more than likely carry these ETFs down with it. When I do decide to enter new positions in these ETFs it will most likely be with small allocations that I look to average into over time.

The last category on my high-yield watch list is master limited partnerships which have held up the best so far in 2013. The Alerian MLP ETF (NYSEARCA:AMLP) is currently sitting very near its 2013 highs and has continued to show impressive relative performance. This is most likely due to the strength in crude oil which recently surpassed $100 per barrel. MLPs own and operate pipelines and energy infrastructure and are able to pass on their profits through tax-efficient dividends to shareholders. This sector has had its fair share of volatility in the past, however with a yield approaching 6% this ETF should be on your high-yield radar screen.

When constructing your income portfolio you should consider adding some high-yield exposure as it can often times diversify and offset high-quality holdings. However, the key is to keep your allocation sizes in line with your risk tolerance and keep a close eye on the price action of these positions. In addition, I always manage these positions with an eye towards risk management and attempt to capitalize on opportunities when they present themselves.

Read more from David Fabian, Managing Partner at Fabian Capital Management:

Implementing A Portfolio Protection Plan

3 Mutual Funds For The Second Half of 2013

3 Great Income ETFs to Buy During This Correction


Twitter: @fabiancapital
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