Income Seekers Must Endure Market Turbulence
‟I don’t have a fear of flying—I have a fear of crashing,” said Billy Bob Thornton, actor and musician.
Like Billy Bob, investors who had described themselves as risk-tolerant when they signed up for their accounts often discover that while risk is easily tolerated, losing money isn’t. Anyone invested in energy or gold companies, and even blue-chip Canadian banks, has been gritting their teeth and digging their nails into the armrests.
There is no return without risk, however, and when low-risk investments like GICs or government bonds pay next to nothing, even retired, income-seeking investors must overcome their fears and get on the plane.
Income-seeking investors might be able to live with quarterly or even annual payments, but it’s nice to be able to count on investments that make the same monthly disbursements. (You would be surprised at the number of securities that offer the convenience of monthly payments, with the added excitement of changing the payout month to month.)
One method of generating a stable monthly income of more than a few percent is via high-yield ETFs. There are 29 Canadian ETFs that pay more than 5% in annual distributions, but 11 of these are for advisors and another 10 are too tiny to be of much interest. As well, many of the small, high-yielding ETFs focus on energy, gold, or material-producing industries and their lack of diversification has caused their unit values to plunge over the past year—volatility that income-seeking investors cannot tolerate. There may be some good small ETFs but by limiting choices to those with a market capitalization of at least $100-million, you eliminate the most volatile funds.
Several exchange-traded funds use covered call options to improve the yield on their underlying holdings. In theory, the act of writing covered calls ought to offer some protection in a market downturn. When you write or sell a covered call option, you’re selling someone the option to buy your shares at a predetermined price before a predetermined expiry date. You pocket the premium, which is supposed to provide you with some downside protection in exchange for the risk of having your shares called away.
Covered call ETFs are an investment product, however, and investment products (which are designed to generate fees for the company that sponsors them) should almost always be avoided. Among other problems, the trading the ETF managers are compelled to conduct adds to the cost of the fund, which makes long-term growth that much more difficult. That said, income-seeking investors should generally be pleased with funds that provide consistently high monthly payments, even if the value of the investment itself remains relatively flat. In most cases, you can have yield or growth, not both. But there are some exceptions.
Below are some ETFs that provide investors with a monthly distribution that amounts to more than 5%, have more than $100-million in assets, and a management expense ratio of less than 0.75%. The eight funds below are listed in descending order, based on total returns over the past five years as shown at etfinsight.ca:
BMO Equal Weight REITs Index ETF (ZRE/TSX) has achieved a total return (dividends plus capital gains) of about 10.7% since it was set up in late 2010. The fund holds roughly 6% of its assets in each of the 17 major Canadian Real Estate Investment Trusts, including such well-known names as Dream Global, Granite, H&R, Calloway, Canadian Apartment, Pure Industrial Morguard, Boardwalk and Riocan. The monthly payout was increased to 8.8¢ from 8.3¢ earlier this year to yield 5.4%. It carries a management expense ratio of 0.62%.
iShares Canadian Financial Monthly Income (FIE/TSX) has fallen more than 7% this year, but still has an admirable 8.6% total return over the past five years. The fund has almost a third of its assets in two other iShares ETFs: The 1-5 Year Laddered Corporate Bond (CBO/TSX), which is flat on the year after a surge in January, and the S&P/TSX Canadian Preferred (CPD/TSX), which is down 15% on the year. The rest of the fund’s holdings include all of the big Canadian banks and insurers. Thanks to the bad year, you can buy the units for less than $7, which means the monthly payout of 4¢ yields about 7.1%, despite a high MER of 0.85%.
The next three funds all have relatively small stakes in hundreds of U.S. high yield or “junk” bonds, defined as those with a rating of BB or lower by Standard & Poor’s. The charts for each fund is practically identical; all three have achieved five-year total returns of between 7.68% and 7.85%.
iShares US High Yield Bond Index ETF
(C$-hedged) (XHY/TSX) yields 5.8% and carries a management expense ratio of 0.67%; the iShares Advantaged US High Yield Bond Index (C$-hedged) (CHB/TSX) has a higher dividend yield, 6.3%, and a lower management expense ratio, 0.56%; the BMO High Yield US Corporate Bond (Hedged to C$) Index ETF (ZHY/ETF) falls in between, with a 5.9% yield and a 0.62% MER, but the difference between the three is minimal.
BMO Emerging Market Bond ETF (C$ hedged) (ZEF/TSX) has achieved a respectable 6.85% total return, without varying too much in price, since it was launched in 2010. The monthly distribution varies, but thanks to an end-of-year payout of roughly double the usual 6¢ a unit, the yield touches 5%. Its management-expense ratio is a surprisingly low 0.5%.
The fund holds 52 government bond issues from Indonesia, Brazil, South Korea, Turkey, Russia, Mexico, Colombia and other emerging-market countries, with most of the debt rated a relatively high-risk BBB.
iShares Diversified Monthly Income ETF (XTR/TSX) is down about 6% this year yet retains a strong 6.83% total return over the past five years. This well-established $708-million fund will celebrate its tenth anniversary in December, although it did not begin monthly payouts until 2010. The fund is an ETF of ETFs, made up exclusively of eight iShares funds, yet carries a reasonable MER of 0.56%. The distribution has been fixed at 6¢ a unit since 2010, which yields 6.4%.
iShares Canadian Preferred Share Index (CPD/TSX) has fallen 15% this year but so far its monthly payout of 6.2¢ has held steady, pushing the fund’s yield to 5.4%. Despite this year’s slump, the fund’s five-year total return has stayed at a positive 2.06%. The giant $1.3-billion fund has holdings in 202 issues of preferred shares from virtually every blue-chip Canadian company. It carries a management expense ratio of 0.5%.
Interested in a high-yielding U.S. ETF? With the Canadian dollar below US80¢, you need to make big gains in U.S.-dollar based investments just to break even, unless: a) you keep your money in a U.S.-dollar account and spend your gains somewhere that the U.S. dollar is accepted at par (Hawaii in February comes to mind), and/or b) you repatriate your investment into Canadian dollars at a time when the loonie is no stronger than it is when you made the purchase.
Even if you are willing to take a chance on an ETF priced in U.S. dollars, you may not be willing to accept the added risk of a U.S. interest-rate hike, which would devastate those income funds that hold bonds. It is less clear that a rate hike would immediately hurt funds holding stocks, however, since an increase in rates would have to be preceded by an increase in corporate earnings, which is always good for stock markets.
Although it has only been around for a couple of years and uses covered call options, BMO U.S. High Dividend Covered Call ETF (ZWH/TSX) looks like a good way to hedge against the Canadian dollar falling further. The fund pays 8.5¢ a unit, up from 8¢ last year, which works out to a yield of about 5.4%. While almost every other Canadian high-yielding ETF has fallen in price, ZWH has tallied up impressive gains thanks to the strong U.S. stock market and the weakening Canadian dollar.
Should you decide to purchase any of these ETFs (or anything else, for that matter), consider holding them in a Tax-Free Savings Account while you still can. The cumulative TFSA limit for 2015 is $41,000 per adult, set to rise to $51,000 in 2016, but if the coming election goes their way, either Prime Minister Mulcair or Prime Minister Trudeau may denounce the TFSA as a “tax loophole for the rich” and change the rules on TFSAs. Even if the Conservatives return with a minority government, the Opposition may demand changes to the TFSA. Government policies are designed to encourage taxpayers to behave in a certain way, but any tax advantage that becomes too popular with taxpayers gets branded a tax loophole and gets cancelled. Just ask those who held income trusts in 2006.
Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca