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These Funds' Yields Aren't Worth the Risks

Morningstar's Alex Bryan spotlights two funds where the risks outweigh the rewards.

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Christine Benz: Hi, I'm Christine Benz for Morningstar. The current low-yield environment means that higher yields often have significant risks attached to them. Joining me to discuss some exchange-traded funds that do have high yields but also high risks is Alex Bryan. He's Morningstar's director of passive strategies research for North America.

Alex, thank you for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, yields are so low today. Let's discuss some of the risks that investors can run into by overprioritizing yield. Investors really love to get income from their investments, but it seems like a really risky time to do so, right?

Bryan: Absolutely. Yield doesn't tell the full story of any investment. So, if you aggressively chase it, it can lead to high risk and subpar total returns. For example, if you think about how high-yielding stocks get that way, there's really one of two avenues: Either one, they're paying out a large share of their earnings as dividends, which leaves a small buffer to preserve those payments should their earnings dry up, or two, they're trading at low valuations, which often reflects weak business fundamentals, and a lot of times it's a combination of those two things. So, if you're just going after yield really aggressively, you can end up owning some stocks that may not be able to sustain their dividend payments, and, even if they can, may turn in disappointing returns.

Now, on the fixed-income side, there's a really strong direct relationship between yield and risk. Higher-yielding bonds tend to carry greater credit risk, greater volatility, greater downside risk. So, it's really important to look beyond just yield because it certainly is not the full picture.

Benz: We're going to delve into a couple of exchange-traded funds that do have attractive yields, but you think the risks are not worth it. So, let's start with SPDR Bloomberg Barclays High Yield Bond. The ticker is JNK. This is a high-yield bond fund. Let's talk about that one and why you think it's so risky.

Bryan: Let me just start by saying that this fund does a fine job representing the composition of the U.S. high-yield corporate bond market. It's just that I think that this is a market segment where most investors shouldn't go for income because not only do these bonds carry considerable credit risk, they're also more highly correlated with stocks than investment-grade bonds as lower-quality corporate issuers' ability to repay their debt is influenced by the business cycle just like stock. So, if you're thinking about your bond portion of your portfolio as the defensive part, high-yield bonds really don't play that role very well. I think you'd be better off, if you're looking for higher returns, just owning more stocks and less bonds. But anyway, high-yield bonds are a very risky area to be. And this particular fund compounds those risks because it is market-value-weighted, so it follows bond-issuing activity, so that drives the composition of the portfolio. It tends to give greater weightings to more heavily indebted issuers, which isn't necessarily the best way to construct a bond portfolio when you're talking about high-risk issuers. So, I think if you really are committed to getting exposure to high-yield bonds, active management is a better way of going than a passive index fund like this. But like I said, for most investors it's probably best to stick to the investment-grade part of the market.

Benz: Now, let's look at equities. I think many investors who are income-focused might be attracted to foreign stocks where we tend to see higher dividend yields than in the U.S. Let's take a fund that does focus on that space but takes a little bit more risk than you're comfortable with. That's SPDR S&P International Dividend ETF. Talk about that one.

Bryan: So, this fund targets the 100 highest-yielding stocks listed outside the U.S. and then weights them based on their dividend yield. So, it is very aggressive in how it goes after yield. It does apply a modest risk adjustment in its selection approach. Basically, it penalizes stocks that have volatile yields over the past three years. But this risk adjustment is very modest and does little to prevent the fund from owning the riskiest names as yield really drives most of the ranking and selection that happens here. Reflecting its preference for riskier dividend-payers, this fund has tended to underperform the market during downturns and exhibit greater volatility. So, this is a fund that really, I think, exemplifies some of the risk of chasing yield. A lot of its holdings aren't able to sustain their dividend payments, and, even if they do, a lot of times they end up providing disappointing returns and high risk along the way.

Benz: Is the broad takeaway that investors should not focus so disproportionately on current income and instead keep in mind the whole mosaic of risk and total return rather than just current income?

Bryan: Absolutely. I think if there's a good rule of thumb, it's that if you're looking at a fund that offers a really high yield, there's probably some risk behind that. It's not a good idea to just focus on yield alone. Remember, there's always the option to realize some capital gains if you need some additional income. You can always sell part of your portfolio to increase the cash flows that your investments generate for you. So, you have the ability to do that with a broadly diversified fund. I think that's a lot of times a lower-risk way than just relying solely off of the distribution payments from a portfolio. Because if you're really looking at the highest-yielding stocks or bonds, a lot of times they come with a lot of risk as well, and that's not necessarily going to help you reach your long-term goals. You want to focus on cash flows that are sustainable, and oftentimes the highest-yielding funds aren't able to deliver that.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.