Five Bond ETFs For Yield-Hungry Investors

by on March 10, 2010 | ETFs Mentioned:

To many investors, last  month’s data release showing that core CPI declined in January for the first time in nearly 30 years was a welcome bit of news. The fact that inflation has yet to rear its head might extend the already prolonged period of low interest rates a bit further, as the Fed looks to give a still fragile recovery all the support possible. Interest rates in the U.S. and many other developed economies have been near zero for some time now, they are often seen as one of the many measures enacted to pull global economies from a deep recession.

While low rates have given a boost to equity markets, they’ve taken some of the wind out of the sails of fixed income investing. With yields on short-term Treasuries near zero, finding a fixed income ETF that delivers a material return is no easy task. Junk bonds–such as the SPDR Barclays Capital High Yield Bond ETF (JNK)–are one popular option for investors seeking current returns, but these funds obviously come with a significant bump in risk as well.

Fortunately, JNK and its competitors aren’t the only fixed income ETFs offering a decent yield in the current environment. Below, we profile five ETFs offering attractive current returns. (A word of caution: there are several different metrics thrown around when evaluating current returns delivered by fixed income ETFs, so comparing apples to apples isn’t always as simple as it perhaps should be. See this feature for a good explanation of the various yield measurements.)

5. Market Vectors High Yield Muni (HYD)

High yield munis account for a relatively small portion of the overall municipal bond market (about 10%) and are often issued by not-for-profit organizations such as hospitals and charter schools. As the name suggests, these debt securities are generally found near the low end of the credit spectrum; about half are not rated while the remainder carry an average rating below investment grade.

But that doesn’t necessarily translate into high default rates. According to a study done by Moody’s Investors Services of fixed-income default rates between 1970 and 2005 (PDF), the average cumulative rolling ten-year default rate for high-yield munis was 4.3% over that period. For high-yield corporate debt, it was nearly 33%.

HYD currently offers a 30-day SEC yield of just over 6.0%, an attractive rate even before considering potential tax benefits. Because interest income from high-yield muni bonds is exempt from federal taxes (and in many cases state and local taxes as well), the effective pre-tax yield can be much higher. For an individual in the 35% tax bracket, HYD’s 30-day SEC yield is effectively about 9.3%.

4. Vanguard Long-Term Corporate Bond ETF (VCLT)

For investors looking to steer clear of anything “high yield,” VCLT may offer an interesting alternative. This fund is linked to an index comprised of dollar-denominated, investment grade securities issued by industrial, utility, and financial companies with maturities greater than ten years.

VCLT’s 30-day SEC yield of 6% and average coupon of 6.7% should be enough to make any fixed income investor’s mouth water, and the average credit rating of A2 should help ease concerns about default risk. VCLT is, of course, exposed to some significant risk factors, including the threat of interest rate hikes. With a duration of more than 12, VCLT could take a hit when the Fed begins its next tightening cycle.

3. SPDR Barclays Capital California Municipal Bond ETF (CXA)

California’s budget problems have been well-documented, and have predictably resulted in an increase in the state’s borrowing costs. This ETF currently exhibits an average coupon of about 4.8% and a 30-day SEC yield of about 4.0%. Similar to HYD, the preferential treatment of interest on muni bonds makes effective yields higher, particularly for investors in higher tax brackets. But similar to VCLT, interest rate sensitivity is a potential concern; CXA has a modified adjusted duration of 11.5 years.

Despite the persistent concerns over deteriorating public finances, CXA’s average credit quality is Aa3, putting it comfortably in the investment grade category. See a complete list of California muni bond ETFs here.

2. PowerShares CEF Income Composite Portfolio (PCEF)

PCEF isn’t technically a bond fund–its holdings consist primarily of closed-end funds–but a significant portion of these CEFs invest in fixed income securities, including both investment grade and high yield issues. PCEF is a relatively new ETF–it launched just last month–but the early reception from investors has been a warm one (average daily trading volume is already about 100,000 shares).

A major draw of PCEF is no doubt the current return; the fact sheet (PDF) for the underlying index puts the current yield at more than 8%. This yield is attributable in part to the nuances of CEF investing (i.e., because many of these products trade at a discount to their net asset value).

1. iShares JPMorgan USD Emerging Markets Bond Fund (EMB)

For investors looking to venture overseas for their fixed income exposure, emerging markets can offer some interesting opportunities. This ETF consists of dollar-denominated debt, and is designed to limit the weights given to countries with higher debt outstanding by reallocating to countries with lower debt burdens. EMB holds debt from approximately two dozen emerging markets.

EMB’s 30-day SEC yield of 5.4% is fairly attractive, as is the weighted average coupon of about 7%. However, it should be noted that the credit ratings of the underlying holdings are all over the board (see a complete breakdown here).

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Disclosure: No positions at time of writing.