Looking at high yield ETFs

One of the advantages of exchange traded funds (ETFs) is that they offer instant diversification. This can be a help when it comes investing in assets that are inherently riskier than average. To some degree there is safety in numbers. One share in an index may go bust, or a bond issuer default, but it is unlikely they all will.
 
That being the case, it should be possible to find a higher than average yield with an ETF, but not run the same risk as plumping for a single high yield share or bond. That at least is the theory. The counter-argument is that a single major default or bankruptcy in a particular area, say an emerging market, might spook the whole sector for a while.
 
Assembling a list of high yield exchange traded funds does, however, reveal some anomalies. One surprising thing, for example, is that several supposed high yielding ETFs yield less than the FTSE 350 high yield index. Almost all yield less than United Utilities (UU-).

On the other hand, United Utilities is a single stock, with a regulated business, high capital spending commitments and low dividend cover. Is that preferable to a yield that has a bond type protection and a more diverse source of income?
 
The high yield ETFs I have looked at, mainly from iShares, the largest provider of ETFs readily available to UK investors, fall neatly into three groups: equity-based; property-based; and bond-based.
 
Yield orientated property index funds are headed by the dollar denominated US property yield iShare, which yields 5.2% and is denominated in dollars. A fund based on Asian property yields 4.6% and one based around yields in the rest of the developed world 4.2%.
 
Equity-based high yield ETFs include the FTSE UK Dividend Plus. This fund currently yields 5.3% and holds a typical selection of high yielding equities including utilities, insurers and others. The yield on this fund is rather better than that now on offer on its European equivalent, the Eurostoxx 50 Select Dividend Plus. The latter stock has risen sharply in recent months, helped by the strength of the Euro.
 
This highlights another aspect of high yield funds, and ETFs generally, namely that the currency denomination needs to be taken into account. If, for example, you assume that the euro is likely to remain strong against sterling, does this compensate for the slightly lower yield, or not? These are tricky questions, but investors have to confront them nonetheless.
 
The final category of high yield ETFs are those based around bonds. Here, investors have another set of questions to ponder. The currency questions are somewhat similar. Corporate bond funds denominated in Sterling and US Dollars yield around the same, about 5.8%, but the Euro denominated one yields about a percentage point less. Given that the bond holdings are arguably of broadly similar quality, is this disparity more or less than offsetting what one can perceive as currency risk?
 
More interesting still is the best yielding exchange traded fund. This is the one that tracks emerging market bonds. It currently yields 6.7% and has a broad spread of maturities and also holds mainly sovereign bonds (ie those issued by governments) in a wide range of countries from Russia and Brazil to Colombia and Indonesia.
 
What is interesting about this fund is that, although it has appreciated significantly in the last six months, its recovery has been markedly less than that seen for example in sterling or dollar denominated bond funds. Yet emerging market equities have been among the strongest performers in the last nine months, vastly outpacing the developed world markets.

Peter says

I am not seeking to make any recommendations here. One's appetite for vehicles of this nature depends on tolerance of risk and whether or not you require your investments to produce income.
 
However, there is one interesting parallel. When the sterling denominated corporate bond iShare sank to a low in early April, it looked anomalous in the extreme, because in the preceding few weeks, bank shares had been rocketing. Since the bond fund was heavily weighted towards bank shares, that didn't look right. And the disparity has since been corrected.
 
There is a strong parallel between this situation and emerging market bonds. Emerging market equities have risen by over 60% in dollar terms since the start of the year with some markets getting close to doubling. Yet the emerging market bond index is up only 24% on the same basis and over the same timescale. This too has to be considered an anomaly that may be corrected in due course.