The recent explosion of exchange-traded funds (ETFs) has provided income investors with many new ways of goosing returns.
However, the ETFs with the juiciest yields can be quite dangerous, as they’re vulnerable to dividend cuts and capital erosion.
Thus, I decided to sort through the universe of high-dividend ETFs and identify those that are both sound and attractive income-boosters – as well as those that are dangerous value traps.
High Risk, High Reward?
The highest-yielding income ETFs specialize in mortgage real estate investment trusts (mREITs). These mREITs invest in residential and commercial mortgages, generally leveraging themselves to do so, and then pay high dividends from the income they generate.
The problem is that rising interest rates can hurt mREITs in three different ways.
First, rising rates reduce the “gap†between fixed rate mortgage receipts and funding costs, thus reducing returns as well as the dividends that the trust can pay.
Second, higher rates reduce an mREIT’s capital value, as the mortgages it holds decline in value.
Finally, if rates rise rapidly, they may produce a wave of mortgage defaults, as the underlying real estate gets into trouble.
Still, if you think rates aren’t going to rise much, an ETF like the iShares Mortgage Real Estate Capped ETF (REM) can offer value.
This $950 million ETF tracks the FTSE NAREIT All Mortgage Capped Index. And even if its 14.8% yield declines a bit – the yield would be 10.8% based on the most recent quarter – it would still be pretty succulent.
These Aren’t the Dividends You’re Looking For
In addition to mREITs, energy master limited partnerships (MLPs) also offer appetizing yields. But there are also plenty of risks here, as well.
Even natural gas MLPs – which may seem less risky, as natural gas prices haven’t cratered quite like oil – are a risky proposition. Many of the underlying companies are running at losses, so an ETF covering them is in severe danger of dividend reductions.
