The market has been observing consistently declining yields ever since the start of the financial crisis in 2008. In the current low yield environment, 10-year Treasury bond pays a mere 1.6% in interest and S&P 500 yields just above 2% in dividends.
Furthermore, we observe negative interest rates in Japan, Switzerland, and Germany.
At the same time, saving account rates in the US are at a record low with no prospects to go higher anytime soon. Oil hit $30 per barrel, and many energy companies that traditionally pay high dividends cut their payout.
The recent UK vote to leave the EU, more concerning news from China and sluggish growth in the US are very likely to delay another rate hike for a long time.
Income-seeking investors are facing challenges in finding safe investments that can provide them with a supplemental income. In their quest for yield, many investors are exploring more exotic asset classes that they have neglected previously. Furthermore, each of these asset classes has specific economic risks and tax treatment. Subsequently, investors interested in higher yielding investments need to understand how each one fits within their risk tolerance and asset allocation target.
For all yield-seeking investors, ETFs represent a low-cost and tax efficient alternative. Therefore we have seen significant inflows into passive high-dividend ETFs in the past few years. We will walk you through the major asset classes that drive that interest. Also, we will show the largest ETFs by Asset Under Management (AUM) in each category.
High Dividend US Equity
Dividends are a significant driver of total returns. Historically, dividend income has accounted for about 40% of the return from stocks, with the remainder coming from growth in earnings and inflation.
DVY, VYM, SDY, SCHD are the most popular ETFs investing in high dividend US equity. As of September 12, 2016, all four ETFs had outperformed SPY by a significant margin. DVY and SDY reported price return of 15.1% and 16.27% versus 6% for SPY.
List of US Equity High Dividend ETFs
Most ETFs tend to invest in companies with a history of consistent or increasing dividend payout. While all of them try to achieve the same goal, they have different ways of doing it. Some ETFs tilt towards large cap finance and utility stocks. Others lean towards mid and small size companies. Most of the ETFs on the list do not invest in REITs and MLPs. They pay qualified dividends which are taxable at the more favorable rate at 0%, 15% or 20% plus 3.8% Medicare surcharge.
The highest risk with this strategy is that companies can cut dividends upon company discretion. Instead of paying dividends, management can direct funds to cover operational expenses or expected losses. For instance, many of the financial companies cut their dividend significantly during the crisis of 2008-2009. Most recently, energy companies decreased their dividends as the price of oil reached $30 per barrel.
Utilities and Energy are among the sectors with the highest dividend payout apart from REITs. There is the list of the largest ETFs invested in these two areas.
International high dividend strategy seeks the highest dividend paying securities outside of US. Investments comprise of a wide range of companies from Europe to Asia and Australia and from large to small sizes.
Foreign stocks have underperformed US stocks consistently for the past ten years. On the other hand, high dividend international stocks have outperformed broad market foreign stock on both absolute and risk-adjusted basis. An additional benefit of investing in this strategy is the lower correlation to the US market which will decrease the risk in a diversified portfolio.
An equity real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties bundled together and offered in the form of unit investment trusts. REITs must pay out 90% of its taxable income to shareholders as dividends.
Consequently, they can deduct dividends paid to shareholders from its taxable income. This income is exempt from corporate-level taxation and passes directly to investors. REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties, prisons, theaters, golf courses, and timberlands.
REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties, prisons, theaters, golf courses, and timberlands.
VNQ dominates the REITs ETF space with$34 billion of AUM.
Mortgage REITs provide real estate financing through the purchase of mortgages and mortgage-backed securities (MBS). They profit by exploring the difference between long term and short-term financing rates. Mortgage REITs are among the highest dividend paying companies. They are also one of the riskiest. They are highly sensitive to interest rates and economic cycles.
There are only two mortgage REIT ETFs – tickers REM and MORT.
Investors who are looking for more diversified exposure may also consider IYR. This ETF invests in a broader range of equity and specialty REITs including mortgage and timber REITs.
Tax Treatment of REITs distributions
REITs dividend distributions for tax purposes come as to ordinary income, capital gains and return on capital, which have different treatment for tax purposes. REIT ETFs must provide shareholders with guidance on how to allocate their dividends in the various categories. The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.
The majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6%, plus a separate 3.8% Medicare surtax on investment income.
Capital gains distribution is taxable at either 0, 15 or 20 % tax rate, plus the 3.8% surtax.
Return on capital distributions are tax-deferred. They decrease the cost basis of the investment. Investors owe taxes on these distributions only after they sell them.
Another favorite dividend alternative for yield-hungry investors is the master limited partnership or MLP. MLPs resemble some of the features of the REITs. They are required to pass at least 90% of their income to their partners/investors. This structure is especially popular with energy companies that own and operate liquid and gas pipelines along with storage facilities and processing plants that bring energy products to market.
List of MLP ETFs and ETNs
MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices. Therefore MLPs as a group is less volatile than the broader energy sector. Bear in mind that 2015 oil prices drop to $30 per barrel negatively impacted many MLPs. As a result, the Alerian MLP Index went down by -38%, triggering sustainability concerns about many of the smaller size MLPs.
Legal Status, Tax Treatment, and Placement
The largest portion of MLP distributions is in the form of return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income.
Due to their legal structure, direct MLP ownership requires federal K-1 tax forms filing in every state in which each MLP operates. MLP ETFs and ETNs address the issues with the filing and provide broader diversification.
ETFs and ETNs have entirely different legal status. MLP ETFs are organized as a C-Corporation. As a result, most distributions are tax-deferred, similar to the underlying MLPs.
ETNs are unsecured debt instruments. MLP ETNs are not backed by underlying securities but by the issuing bank’s promise to pay. Because of that, MLP ETN distributions are treated as ordinary income.
Both structures can suit different types of investors. All tax, economic and legal issues need to be considered carefully before purchase.
Preferred stocks are a hybrid between equity and fixed income. They trade on the stock exchange. These shares represent a special ownership in the equity of a company with a fixed dividend payout. Preferred stocks do not usually give voting rights, but offer a higher claim on assets and earnings than common stock.
PFF leads this segment with over $17 billion of AUM.
Preferred shares are less volatile than common stock. They have a lower downside risk but also smaller upward potential. They are suitable for investors seeking more reliable income and less interested in price return.
Traditionally the financial sector is the primary issuer of preferred stock. For that reason, these asset class was hurt very hard during the financial crisis in 2008-2009. Furthermore, many of the high-yielding preferred stocks currently available on the market were issued during or after that same recession.
Investors interested in preferred stock will face credit risk. The average credit rating of the issuances held by major ETFs is BBB, which is the lowest investment grade rating. The credit rating determines the ability and risk of the issuer to pay off its debt.
Preferred stock investors have exposure to interest rate risk. Preferred shares are inversely related to changes in interest rates. Therefore, their value will decrease as interest rates go up and increase as rates go down.
Preferred stocks are positively correlated with the equity market. Their seven-year correlation to US market is equal to 0.6. While their correlation with the broad bond market is 0.2. Preferred shares are not as volatile as equity stocks and have more predictable returns.
In the current low-interest environment, the issuers of preferred stocks (such as like Wells Fargo, HSBC, Barclays, Citigroup, Deutsche Bank) can decide to call them back, convert them to ordinary stock or replace them with lower yielding alternatives.
U.S. corporation can exclude up to 70 percent of the preferred dividend from their taxable income as long as they hold the shares at least 45 days.
This benefit is not available for individual investors. For them, the dividends are taxable on the full amount at the favorable rate for qualified dividends – 0%, 15%, and 20%.
Due to their high dividend, favorable tax rate, and low expected volatility, the preferred stock ETFs are a suitable option for all investment type accounts.
High Yield Bonds
High Yield Bonds are fixed income securities issued by companies with below investment grade rating. To attract investors, high yield issuances offer a higher yield. Currently, an average high yield bond pays 2% more than comparable investment grade bond. Also known as junk bonds, they present a much higher credit risk compared to equivalent investment grade bonds. Their embedded credit risk rating ranges between BB and CCC.
HYG and JNK are the most popular ETFs in the High Yield space with AUM of $15 billion and $11 billion respectively.
Similarly to preferred stocks, high yield bonds have a positive correlation with both equity and bond markets. They have much stronger correlation ratio to the US markets, 0.76, versus US bond markets, 0.2. This relationship extends from the issuer’s ability to pay off the debt, which more often depends on the success of their business model rather than changes in interest rates.
High yields bonds over-perform comparable investment grade bonds during a stable economy cycle and a low-interest environment. Rising rates, increasing credit spreads, recession and spike in business defaults will negatively affect high yield bond markets. In these cases, the value of the bonds will decline driven by adverse factors that will lower the issuers’ ability to pay off current debt.
For individual investors, high yield bond ETFs provide much better diversification than holding individual bonds. The largest ETF, HYG, owns over 1,000 bonds. Without significant investment in research, ETFs offer low-cost alternatives into the high yield bond segment versus mutual funds.
Investors in high-yield bonds pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.
Due to their high tax rate and greater volatility than other fixed-income instruments, high-yield bonds are more suitable for tax-exempt and tax-deferred accounts.
Emerging Market Bonds
Emerging market bonds are government and corporate bonds issued by states and companies from the group of emerging economies. Primary EM bond issuers come from countries like Mexico, Turkey, Philippines, Indonesia, Russian Federation, Hungary, Brazil, Poland, Colombia, South Africa, and few others.
EMB and PCY are the leading Emerging Market Bond ETFs. Their AUM is $9 billion and $3.9 billion respectively. Like other investment classes, ETFs investing in emerging market bonds offer diversified regional and industry exposure.
Frequently, emerging bank bonds receive a below investment grade rating, which shows the significant credit risk to bondholders. There have been many examples of emerging economies not being able to pay off their debt. The most recent case was Argentina and Brazil. In the not so distant future, Russia and Turkey had similar troubles. The International Monetary Fund (IMF) or the World Bank often intervene in a case of country debt default.
In addition to credit and interest rate risk, investors in these securities have exposure to currency risk. For instance, a significant depreciation of the local currency can significantly undermine the USD value of the bonds from that country.
Similarly to high yield, emerging market bonds have ties to both equity and bond markets. They have an equal correlation to US equity and bond markets with correlation ratio equal to 0.48.
Investors in Emerging market bond pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.
Similarly to high yield, the emerging market bonds come with a high dividend, unfavorable tax rate, and higher expected volatility. Due to these factors, high-yield bonds are more suitable for tax-advantaged accounts such as Roth IRA, 401k, and Traditional IRA.
Municipal bonds are debt securities issued by municipal authorities like states, counties, cities and their related companies. The primary objectives of Municipal bonds are funding general activities or capital projects like building schools, roads, hospitals, and sewer systems.
The size of the muni bond market is equal to $3.7 trillion dollars. There are about 350 billion dollars of Muni bonds issuance every year.
MUB is the largest Muni ETF with AUM of 7.6 billion dollars. It holds a broad basket of national municipal bonds with intermediate maturities.
Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates go decline, the bond prices will rise.
Individual municipal bonds and municipalities receive a credit rating by major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the issuer to pay off its debt.
Unlike corporations, which can go bankrupt and disappear, municipals can’t go away. They have to continue serving their constituents. History proves that municipal bonds have much lower default rates than comparable corporate bonds.
To encourage people to invest in Municipal Bonds US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. Furthermore, when the bondholders reside in the same state as the bond issuer, they do not pay state taxes.
Therefore, the majority of the municipal bond issuances enjoy tax-free status. Bondholders do not pay federal taxes on the coupon received from these securities. Besides, investors residing in the same state enjoy a state tax-free status as well.
Particular Municipal bonds related to business activities can affect their owners’ AMT status and potentially increase annual taxes.
Also, there is a small but growing group of taxable municipal bonds. These issuances relate to activities that do not provide a significant benefit to the general public.
Tax Exempt Municipal Bonds are only suitable for taxable accounts where investors can take advantage of their tax-free status.
Finally, investors interested in taxable or AMT bonds can consider placing them in their tax-deferred accounts like IRA and 401k.
About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.