On January 25, the Federal Reserve sent a clear message to investors. By announcing their intention to keep interest rates low for the next three years, they effectively said, "If you are looking for a decent yield, you have to invest somewhere other than U.S. Treasuries."
While the Fed only directly controls the short-term Fed funds rate, their policies and open-market activities influence all the treasury products. And if they intend to keep rates low, they can do it.
With a 10-year note that is yielding less than two percent, what is a fixed-income investor to do?
As the editor of the ETF Master Portfolio, I am constantly looking at income yielding ETFs. And there are several out there that have yields greater than 4%. My recommendation would be to build a portfolio of these dividend yielding ETFs and, by using a blend of conservative and moderately aggressive funds, build a portfolio with a yield of more than 5%. Let me show you how.
One example portfolio that I like uses three different ETFs. One is very conservative, one is pretty conservative and the third one is pretty aggressive. The iShares TIPS Bond (TIP) invests in inflation protected treasury bonds and is very conservative. The PowerShares Build America Fund (BAB) invests the bulk of its assets (80%) in Build America Bonds. Build America Bonds were introduced as part of the American Recovery and Reinvestment Act of 2009. These bonds are taxable bonds issued by state and local governments; the interest from the bonds is subsidized by the U.S. Treasury. The SPDR Barclays Capital High Yield Bond Fund (JNK) invests in corporate junk bonds.
At the present time, TIP yields 4.11%, BAB yields 5.22% and JNK yields 7.73%. An equally balanced portfolio with these three funds would thus have an average yield of 5.68%. When you consider that the 10-year note is yielding a whopping 1.93%, the risk to reward for a portfolio of these three ETFs makes a lot of sense.
While I would not typically recommend that individual investors invest in individual junk bonds, JNK has 222 different holdings in the fund, insulating investors from defaults. BAB had 313 different holdings as of February 2. With certain states and municipalities at risk of default, I find comfort in the BAB having so many different holdings.
To give you an idea of how this portfolio would have performed over the past year, I put together the chart below. As you can see, JNK moved in synch with the S&P 500 and, as a result, it struggled in the summer and fall. However, while the S&P and JNK were struggling, BAB and TIP were still moving higher, balancing out the loss on the JNK.
Granted, last year was a rough one for the stock market, but the domestic fixed-income markets held up well. The portfolio as a whole would have produced a gain of 15.52% while the S&P gained 1.65%. The table below shows how a portfolio of the three funds would have performed against a portfolio invested in just the S&P 500. This is only one year, but it was one volatile year.
The diversification between the three funds and the added diversification within the funds gives investors an extremely well diversified portfolio with very little risk of defaults impacting the portfolio significantly. The portfolio can experience capital gains as well as the income returns it produces, and it has an inflation hedge built in with TIP.
The ETF Master Portfolio is a well rounded portfolio of ETFs and fixed income is part of that total picture. JNK is currently part of the portfolio with the attractive yield and the ability to move higher with the stock market. Trying to protect and grow a portfolio includes fixed-income investments.