3 Funds for Yield-Seekers

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many investors love income, but focusing disproportionately on yield can invite risks, too. Joining me to discuss that topic is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about how equity investors can encounter some peril sometimes in chasing yield. In fact, there's that famous quote that more money has been lost by chasing yield than at the point of a gun. That's a little bit dramatic. But investors can get themselves into trouble. Let's start with the equity piece, investors who are disproportionately focused on dividend alone at the expense of some other considerations.

Bryan: So, if you think about how high dividend yields happen, there's really one or two ways that you get there. Either one, a company is paying out a large share of its earnings as dividends and that leaves less money to reinvest back into the business. It also leaves less of a cushion to continue those dividends should earnings fall, which can happen from time to time. So, that's one way that you can get to a high dividend yield. The second way is if you're trading at really low valuations. And oftentimes, low valuations are indicative of high business risk. So, the company may be going through some operational challenges, may be experiencing some slow growth. So, its earnings and potentially its dividends could be cut sometime in the future.

I think chasing yield can lead you to some riskier areas of the market, where yes, a company may have paid out a really fat dividend in the past, but there's a risk that it may not be able to continue that. There's lots of examples of companies that have had high yields but have had to cut, like GE, ConocoPhillips. So, it's important to look beyond just the dividend yield and look at the whole picture to make sure that those dividends are sustainable. And more importantly, to make sure that you are not going to buy into a stock with deteriorating fundamentals. Because even if you are earning a really nice dividend, if you are losing a lot of money from the stock price going down, you're not really benefiting from that.

Benz: Let's talk about fixed income. The risks of focusing strictly on yield when you are shopping among fixed-income instruments. What are the problem spots potentially?

Bryan: So, nowhere is there a stronger link between risk and yield within the fixed-income market. So, anytime you are chasing yield within fixed income, you are typically going to venture into riskier areas of the market, be that securities with greater credit risk--meaning greater risk of default--or securities that have greater interest-rate risk. So, there's a pretty strong link between risk and yield within fixed income. So, you just want to make sure that you're not biting off more risk than you can chew, particularly if you are looking at securities that have a lot of credit risk. Credit risk tends to be highly correlated with equity risk. So, if you dip into the high-yield area of the market, a lot of times you might lose some diversification benefits that safer bonds might provide.

Benz: Let's talk about some yield-producing funds that you like, that you feel like nicely do deliver income while also addressing some of these risk factors. You've kind of arranged them from most conservative to a little more aggressive. So, let's start with the conservative idea.

Bryan:

So, in terms of a more conservative pick for income generation, I like sticking within the investment-grade part of the market for investors who are a bit more risk-averse. But if you were to invest in something like the

So, you get a little bit of a yield pickup by owning corporates rather than Treasuries or agency debt, but the risk profile is still pretty conservative. This is a really well-diversified portfolio, so even if you have a few payers that get downgraded, the impact from the overall portfolio should be quite modest. So, I think that's a pretty good pick. It's one of the cheapest options in the category. It charges only 6 basis points for basically the entire U.S. investment-grade corporate market.

Benz: Your next fixed-income ETF that you like that delivers income but controls for some of the risks is a high-yield product. Let's talk about that.

Bryan:

So, this is a bit more aggressive in that it ventures into the high-yield market. But this is the

It is riskier than my last pick, because high-yield bonds do have greater risk of default. But I think this is a really good option, because one, it's using market information yields to try to mitigate risk by favoring the lower-yielding high-yield bonds. And two, it's really well-diversified. So, again, here, defaults or credit rating downgrades within a few areas of the market aren't necessarily going to have a big impact on this overall portfolio. So, I think, this is a really good option for investors who want a little bit more yield but want to get that in a risk-controlled way.

Benz: And just to clarify, high-yield in any individual investor portfolio would typically be kind of a supporting player holding it, would not be a core fixed-income position, right?

Bryan: That's right. That's right. Yeah. So, high-yield bonds--even the relatively less risky part of the high-yield market--that's actually pretty highly correlated with stock holdings. So, you should kind of think about your high-yield bond sleeve really as kind of like an equity-type replacement rather than a core bond replacement. Because again, you are taking on quite a bit more risk here than you would get with an investment-grade bond fund.

Benz: Let's talk about your last pick. This is an equity fund.

Bryan:

So, this is

And number two, because this portfolio owns half of all U.S. dividend payers, it's really well diversified. So, if a few companies in the portfolio cut their dividends or run into some operational difficulties, it shouldn't have a huge impact on the performance of the overall portfolio. This is also one of the cheapest dividend strategies available. It charges 6 basis points and that's made this very difficult for active managers and smart beta dividend strategies to beat this particular index fund. So, this is one of my favorite picks and I think it's a good option for getting a bit more yield but not taking on too much risk.

Benz: Alex, always great to hear 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.com.

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