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These ETFs Are a Good Place to Look for Income

Jeremy Glaser
Samuel Lee

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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Glaser: Is there any free lunch, or any area that maybe you can get some of that extra yield without taking on a huge risk or taking on a very expensive investment?

Lee: The best places are probably high-yielding asset classes that are a step or two below the highest-yielding stuff. So, one of my favorite asset classes right now is a short-duration high-yield bonds. So, PIMCO has a great ETF out. PIMCO 0-5 Year Corporate Bond Index, HYS is the ticker, and right now that's yielding about 5.5% yield to maturity. That's not a great eye-popping yield, but shorter-maturity junk bonds tend to be a lot safer than their longer-duration junk bonds. So, I do not advise people to go too far out on the maturity spectrum or too low on the credit-quality spectrum when they're looking for yield.

Glaser: So, another area that has really gathered a lot of investor interest is emerging-markets debt. What do you think about that area?

Lee: I think emerging-markets debt is interesting, but the yields are not very hyped. So, a lot of investors know that emerging markets have better, nicer balance sheets than the U.S., and they've priced the emerging-markets bonds accordingly. So, you are not going to get eye-popping yields there, but I think a small portion of your bond allocation in emerging markets can make sense.

Glaser: What are some of your favorite products for accessing the emerging-markets debt?

Lee: There are two. One is WisdomTree Emerging Markets Local Debt, ticker ELD, and this one is denominated in the local currency, so you have some currency risk there. It doesn't sport an eye-popping yield, somewhere around 4 percentage points. And another one is PowerShares Sovereign Emerging Market Debt, ticker PCY, and that one yields a bit higher 5-6 percentage points, and it's denominated in U.S. dollars, so you don't have that currency risk.

Glaser: How about Europe? Certainly there seem to be some opportunities but also a lot of risks there. Is that an area that makes sense right now?

Lee: I think it does. Europe right now yields about 4 percentage points. That's quite an attractive yield, especially relative to the U.S. and relative to cash. So, historically broad stock markets like the U.S. and Europe in aggregate have grown their per-share real dividends by about 1.5 percentage points annually. So, you just add 4% current yield plus 1.5%-per-share real dividend growth, and you can reasonably expect a 5.5% real expected return over a long period of time, not next year or this year, but over 10, 20 years. That's very attractive relative to cash. Cash right now is yielding a negative 2 percentage points. So, you basically have a 7.5% equity risk premium over cash, and that's quite attractive.

Glaser: What are some of those funds that have a European exposure?

Lee: Right now my favorite European ETF is Vanguard, MSCI Europe ETF, ticker VGK, and that's probably the best European exposure out there. I do like Europe as a yield opportunity because you not only have that yield, but you also have the chance of a revaluation. So, right now Europe is trading at depressed valuations because of the eurozone crisis, but there is a good chance that the eurozone crisis will pass not soon, but in five or 10 years and you might have the chance of capital gains appreciations as those valuation multiples normalize.

Glaser: Well, Sam thanks for talking with me today, and we're looking forward to the webinar on Oct. 30.

Lee: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.