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By Jeremy Glaser and Samuel Lee | 10-23-2012 10:00 AM

These ETFs Are a Good Place to Look for Income

Eye-popping yields are scarce for many bond ETFs, but Morningstar's Sam Lee points out some attractive funds that focus on corporates, emerging markets, and Europe.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What's the best way to generate income with exchange-traded funds? I'm joined today by Sam Lee. He's the editor of Morningstar ETFInvestor. He's also going to be hosting a webinar about how to generate income with ETFs. That's going to be on Tuesday, Oct. 30.

Sam, thanks for joining me.

Sam Lee: Thank you for having me here.

Glaser: So, let's start with the big question about why people are so concerned about generating income now. It used to be relatively easy, maybe you bought some certificates of deposit; you could look at the bond market. But with rates so incredibly low, what's forced interest rates down so much? Is it just the Federal Reserve? Is it the economy? What's happening there?

Lee: It's both the Fed and the economy. So, prior to the financial crisis, a lot of people took out a lot of debt. So, they leveraged up their balance sheets, and when the financial crisis struck, they were left with lots of leverage and assets that they bought with this leverage that was devalued, such as housing. So, they have this huge debt overhang. When you're in this kind of debt-overhang situation, people are not interested in borrowing more, no matter what interest rates are. So, they put all their money toward paying down their debt. Until this debt overhang ceases, it's likely that people are going to be more interested in saving and paying down their debts than rather investing in new things.

Glaser: If rates are really low right now. Do you expect them to stay low for a while? Do investors really need to be prepared for years of this?

Lee: Yes, in prior situations in which this debt overhang situation has occurred, interest rates have stayed low for decades, and as the experience has borne out so far, interest rates have stayed low contrary to many investors' expectations. And you can also expect, I think, the government to also keep interest rates low because their debt levels are very high. The government has no interest in letting interest rates rise. So it's this process of financial repression in which interest rates stay very low and inflation is moderately high, so this debt is silently liquidated over a period of many years.

Glaser: Certainly, this sounds like a difficult environment to be looking for yield, but a lot of the ETF providers who have recognized this have come out with a slew of new products--the ETFs, the exchange-traded notes--to try to provide those much higher levels. What do you think of these new products? Are they really something investors should be considering?

Lee: I think these products could be very dangerous. A lot of them use leverage or they deal with the riskiest, least liquid parts of the market. So, these products are clearly designed to sport eye-popping yields, but eye-popping yield is not something you want necessarily in your portfolio. So, I would look at them with a very skeptical eye.

Glaser: Those high yields could be a red flag. What are some of those new funds that you think investors maybe should avoid?

Lee: So, there's one fund that's a double-leveraged mortgage REIT ETN. Not only is it double-leveraged on top of an already-leveraged asset class, but it comes within an ETN wrapper, and the ETN wrapper itself bears some credit risks. So, you're stacking on risks on three levels, and this is not a very attractive product from that perspective.

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