Despite all the talk about Fed rate hikes, it's still hard to come by yield for U.S. investors. The U.S. 10-year yield remains exceptionally low—around 1.70%—with no signs of an imminent rise.
Some believe rates will stay low for the foreseeable future due to demographics, weak economic growth, tepid inflation and easy monetary policies around the world. If that's the case, investors may have to be more creative, or take on more risk, to get higher returns from their fixed-income investments.
Plethora Of Fixed-Income ETFs
In the ETF world, fixed income is an area that is growing rapidly. There are currently 309 exchange-traded funds listed in the ETF.com fixed-income channel, each targeting a different segment of the enormous market.
Returns for the various products have varied greatly. Some funds promise high yields, but deliver poor overall returns. Others are under the radar, but manage to deliver exceptional returns year after year.
Here we take a look at some of the most consistent fixed-income products that have delivered strong returns and look poised to continue to do so.
At a time when junk bond ETFs broadly have performed quite poorly, the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL | C-51) stands out, with a three-year return of nearly 20%. Compare that with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68), which has only seen a 7.6% return in the period.
3-Year Returns For ANGL, HYG
ANGL targets "fallen angels," or bonds that were recently downgraded from investment grade to junk status. The hope is that the issuing company has merely fallen on temporary tough times, and that the bonds may be upgraded back into investment-grade status down the line.
This strategy of buying falling angels has outperformed not only in the last three years, but over longer time periods—10 and even 20 years.
ANGL has a hefty 30-day SEC yield of 6.44% that is comparable to that of the broad-based HYG, but with the benefit of a higher-quality portfolio of bonds. The “30-day SEC yield” is the yield earned by the average investor during the most recent 30-day period.
Municipal bonds ETFs are among the safest investments in the world. While not considered "risk free" like Treasurys, local government debt in the U.S. has historically had very low default rates. According to Moody's, the default rate for muni bonds was around 0.03% during the past five years, and only 0.01% in the 30 years before that.
Even for municipal bonds at the riskier end of the spectrum, the default rates are significantly lower than for corporate bonds. According to Nuveen Investments, the 10-year default rate for muni bonds rated Ba was 3.53% compared with 19.27% for corporate bonds rated Ba.
Amid this backdrop, ETFs like the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB | C-59) have performed quite well. HYMB and the competing VanEck Vectors High-Yield Municipal Index ETF (HYD | C-59) gained 19.3% and 15.3%, respectively, in the past three years.
3-Year Returns For HYMB, HYD
Currently, HYMB has a 30-day SEC yield of 3.73%, while HYD has a 30-day SEC yield of 3.96%.
Income from muni-bond ETFs is exempt from federal income tax, which boosts the taxable equivalent yield of these funds significantly depending on an investor's income tax rate.
Dollar-Denominated EM Bonds
Emerging markets have a reputation for being a risky area to invest in―and for good reason. From volatile stock swings to debt defaults, emerging market assets have faced enormous challenges throughout their history.
However, one area of emerging markets that's been relatively well-behaved is dollar-denominated debt. When times get tough, struggling emerging market governments may be inclined to default on their local-currency debt or print money to pay it back. But they don't have that same luxury when it comes to dollar-denominated debt.
Defaulting on this type of debt would lock those governments out of the global financial markets and be a worst-case scenario, which they would like to avoid at all costs. Currently, even the lowest-rated governments continue to pay interest on their dollar-denominated debt.
Thus, dollar-denominated emerging market ETFs are a great way to capture higher yields, while taking on a manageable amount of risk. The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY | B-60) currently has a 30-day SEC yield of 5.36%, while the rival iShares JP Morgan USD Emerging Markets Bond ETF (EMB | B-58) has a yield of 5.09%.
Because they are dollar-denominated, investors in these ETFs don't have direct currency risk. However, declining emerging market currencies make it harder for the governments to pay interest on the bonds―effectively increasing credit risk (rising emerging market currencies have the opposite effect).
PCY is up 16.4% in the last three years, while EMB is up 13.1% in that period.
3-Year Returns For PCY, EMB
Preferred stock exchange-traded funds are among the best-performing fixed-income ETFs in recent years. The PowerShares Financial Preferred Portfolio (PGF | C) and the PowerShares Preferred Portfolio (PGX | B) each gained nearly 26% in the last three years.
3-Year Returns For PGF, PGX
Preferred stocks have characteristics of both equity and debt. They typically offer a sizable dividend that's safer than the dividends on a company's common stock, but not as safe as the interest payments on a company's bonds. Additionally, preferred stock can sometimes be converted into common stock.
Preferreds are essentially a way to capture higher yields than corporate bonds, but with higher risk if the company faces hard times.
Pricewise, PGF and PGX have been remarkably stable over the past seven years, and both have 30-day SEC yields in the 5.5% range. However, they fell off a cliff during the financial crisis in 2008/2009, illustrating that they are susceptible to significant sell-offs if the economy takes a big enough hit.
Contact Sumit Roy at [email protected].