Stable, High Yields (Bonds Not Included)

This article first appeared in the December 2010/January 2011 issue of Morningstar Advisor magazine. Sign up for your free subscription here.

Investors have continued to pour assets into bond funds in pursuit of stable returns. Since 2009, quarterly net flows into bond- focused mutual funds and exchange-traded funds averaged just more than $92 billion, and the trend doesn't seem to have eased off. Bonds funds saw $89 billion in net flows during the third quarter of 2010. Sustained inflows and loose monetary policy have depressed yields, prompting worries about a bubble. Will the bubble pop, and if so, what might the repercussions be?

Investors expecting anemic economic growth might buy bonds at today's rates. If inflation ramps up, however, current yields are likely to rise and bond prices are likely to fall. Higher inflation could generate losses for today's bond investors, a timely concern given the likeli- hood of a second round of quantitative easing.

Yield-focused investors face stable returns on the one hand and inflationary losses on the other. In this screen, we use Morningstar Principia to identify high-yielding, liquid ETFs outside of the bond space.

Filtering out municipal and taxable bonds, we focus on ETFs whose 12-month yields are greater than 4.5%.

Security Type = ETF
And Morningstar Category not = Municipal bond
And Morningstar Category not = Taxable bond
And 12-month yield > 4.5%

As of Nov. 1, 21 ETFs passed this screen. Morningstar Office users can further refine the screen to find ETFs with all the above qualities and also maintain daily trading volumes above 25,000 shares; out of the 12 ETFs that jumped through all of these hoops, these stood out.

iShares S&P U.S. Preferred Stock Index PFF
Our screen returned a number of preferred- share funds; this isn't surprising: Preferred equity securities offer consistent high yields.

IShares S&P U.S. Preferred Stock Index delivers a high and stable yield--7.24% as of the end of October. With a three-month average daily volume of 1,428,970 shares, a net expense ratio of 0.48%, and net assets of just less than $6 billion, the fund is the largest, cheapest, most liquid, and highest-yielding preferred-stock-focused ETF on our list.

There are, however, risks here. With more than 85% of assets soaked up in financial companies, there's large sector-specific risk.

Preferred shares have historically qualified as Tier-1 capital. Banks used them to satisfy regulatory capital requirements while avoiding the stock dilution that results from issuing common shares. The Dodd-Frank act disqualifies a number of preferred trusts as Tier-1 capital, so issuers are likely to call those shares away at the soonest possible buyback date. While a number of preferred offerings trade at premiums, a majority of which are not callable until 2013, investors looking to take a position here should expect to see premiums decline and share prices return to trading at or near par by the call date.

The largest concern of advisors using this screen should be that preferred shares face the same inflation risk associated with bond holdings. This fund made a substantial recovery after the financial collapse. Volatility, as measured by standard deviation, was 33% during the past three years, greater than the 22% risk in the S&P 500. The fund's positive return during the past three years, however, has enabled its risk-adjusted return to beat the S&P 500 handily.

iShares FTSE NAREIT Mortgage Plus Capped Index REM and iShares FTSE EPRA/ NAREIT Developed Real Estate ex-U.S. Index IFGL
Real estate investment trust funds had the largest showing in the results of our screen. REITs are legally obligated to distribute no less than 90% of taxable income on an annual basis and have thus paid consistently high dividends. Furthermore, these vehicles do not pay entity-level taxes. While most of their dividends are taxed as ordinary income, portions of the dividend exceeding the REIT's taxable income will be considered return of capital and remain untaxed. This return of capital lowers the investor's cost basis and creates a taxable capital gain upon sale of the security. Note, however, that long-term capital gains rates are set to increase to 20% from 15% at the end of 2010. Yields have and should continue to remain high across the space, though investors should consider that these funds' underlying REIT constituents vary in regional focus and investment type.PAGEBREAK

Among the search results, iShares FTSE NAREIT Mortgage Plus Capped Index distinguishes itself by maintaining a 10.69% 12-month yield. The fund primarily holds U.S.-based mortgage REITs. These REITs typically sell short-term paper at low interest rates to finance the purchase of higher-yielding agency mortgage-backed securities.

Mortgage REITs typically turn their paper over on a monthly basis, as opposed to the lengthy 20- and 30-year expirations of agency mortgage-backed securities. New REIT debt securities issued at higher interest rates would shrink the REITs' profit spreads in the near term--interest rates for agency paper are fixed. While the yield here is enticing, investors can find high, stable yield elsewhere in the REIT space without risking exposure to inflation-driven diminishing profit spreads.

IShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index provides exposure to the equity REIT securities of mature real estate markets outside of the United States. The fund provides exposure to 10 distinct real estate markets: Hong Kong, Japan, Australia, Singapore, the United Kingdom, France, Canada, China, the Netherlands, and Sweden. The fund commands just less than $390 million in net assets and yields 7.39%.

The fund's equity REIT holdings should serve to hedge inflation in their respective nations while making consistent and respectable distributions. Foreign-exchange risk should, however, be considered before taking a position here.

JPMorgan Alerian MLP Index ETN AMJ
Master limited partnerships are publicly traded partnership units that concentrate their operations in the transportation of petroleum liquids, such as gasoline, oil, and natural gas. Most pipelines are natural monopolies, and they are the cheapest way to transport liquids and gases over long distances. New developments must justify their economic viability before construction can begin, so few existing pipelines face direct competition. Revenue is linked to volume, not the far-more-volatile prices of the transported commodities. The pipelines that MLPs own usually don't require significant variable input costs for maintenance. These characteristics result in significant free cash flow. Like REITs, MLPs must distribute no less than 90% of their revenues to shareholders, so distributions can be sizable.

On top of stable and sizable distributions, pipelines carrying petroleum products are allowed to increase per-barrel-mile tariffs in accordance with year-over-year change in the producer price index plus 1.3 percentage points. Rate ceilings are set and enforced by the Federal Energy Regulatory Commission and are adjusted annually to accommodate changing market conditions. As long as volume holds reasonably steady, a liquids pipeline holding is a good inflationary hedge that provides yields much higher than Treasury Inflation-Protected Securities. There is always risk of regulatory change, operational complications, or a decline in volume.

With a 12-month yield of 5.49% and net assets of nearly $2 billion, JPMorgan Alerian MLP Index ETN is the largest and most liquid MLP offering among ETFs. During the past year, the fund's Sharpe ratio was 2.5, greater than the S&P 500's 0.6 Sharpe ratio.

While MLP securities' direct shareholders are granted the ability to defer taxes on a majority of their distributions, this tax advantage is lost in this fund because of the ETN structure. On the upside, the fund allows shareholders to avoid the exhaustive K-1 tax-filing process required for direct ownership. Moreover, this MLP offering should continue to provide relatively high and stable yields while simultaneously hedging against inflation.

Abraham Bailin is an ETF analyst with Morningstar.