FMD Capital Management

Why High Yield ETFs Have Stumbled And How To Play Them

Written by David Fabian, June 04th, 2013

Investors have been diligently seeking to increase their yields all year while continuing to take more and more risk to boost their income streams. This phenomenon has been spurred by the Federal Reserve’s zero interest rate policy which has pushed even conservative investors into uncharted high yield waters.

In today’s reality, equity-income investors have to stretch to earn the type of yield that they have been accustomed to in order to maintain their lifestyle and income needs. That is why so many investors are focused solely on the percentage yield of an investment without fully understanding how they are generating those dividends and what the risks are. However, the month of May sent many high yield asset classes stumbling and reasserted the adage that high yield = high risk.

One of the biggest declines was in the area of mortgage REITs as the iShares Mortgage REIT Capped ETF (REM) fell 12.77% last month. This sharp decline was largely due to the impact of rising interest rates which negatively affected the 30 underlying stocks that comprise this ETF. Mortgage REITs are particularly sensitive to rising interest rates because of how their income is generated by pocketing the spread between borrowing short-term debt and leveraging long-term mortgage bonds.

Right now the chart of REM resembles a falling knife, which is why I would avoid mortgage REITs in favor of less volatile income ETFs. The pickup in volume (shown at the bottom of the chart) along with the price having pierced its 200-day moving average is an ominous sign of a new down-trend in this sector.

Another asset class that has begun to see some volatility in the last week is the iShares U.S. Preferred Stock ETF (PFF). Preferred stocks have enjoyed a period of low volatility and high income over the last year; however, they are finally starting to catch up to the rest of the market. This sector is starting to work off some of its overbought momentum, which will bring its valuations down to more attractive levels.

PFF has pierced through its 50-day moving average and is rapidly approaching the 200-day moving average, which may be a good spot for a starter position in this sector. I warned about the potential for a correction in PFF several weeks ago and believe that this dip will be an opportunity to put new money to work in preferred stocks. However, you will want to wait until the dust settles before making a new allocation.

The last high yield sector that has experienced some heightened volatility is the iShares High Yield Corporate Bond ETF (HYG). This ETF has fallen more than 4% from its high, which is a similar drawdown to equity income funds such as the iShares Select Dividend ETF (DVY). Credit spreads on high yield bonds are starting to widen along with the impact of rising interest rates, which is putting downward pressure on HYG.

According to Index Universe, HYG has experienced outflows of nearly $1 billion year-to-date, which may be a sign of investors banking gains and looking to shorten the duration of their fixed-income portfolios. Like PFF, I am watching the price action of HYG very closely as it nears its 200-day moving average. High yield bonds are becoming more attractive at these prices and still represent an opportunity for excellent income and capital appreciation if interest rates stabilize. My favorite ETF for playing the high yield bond sector is the PIMCO 0-5 Year High Yield Corporate Bond Index (HYS) because of its shorter duration.

The best course of action if you are considering adding high yield to your portfolio is to start small and average into any new or existing positions. There is no way to tell at this point how deep this correction will be, which is why patience and planning will be the keys to success. By using this sell off to your advantage, you can make opportunistic purchases while still keeping in mind sound risk management practices.