Seeking Income with ETFs
E*TRADE from Morgan Stanley11/01/21
Are you looking for ways to potentially generate income with your portfolio—perhaps from dividends or interest earned? Income seekers can consider several types of investments, including mutual funds, but in this article we’ll focus on exchange-traded funds (ETFs). When an ETF owns income-producing investments, like bonds or dividend-paying stocks, it passes on that income to investors who hold the ETF’s shares.
Important risks to consider
Before we look closer at ETFs, let’s talk about the risks that every investor should understand when they consider income-oriented investments. The first is inflation risk. Inflation reduces the value—that is, the buying power—of any future income that you may receive. Investors need to consider whether inflation may outpace the income provided by a particular investment, especially if the inflation rate rises in the future.
What’s known as interest rate risk is another key factor. Let’s say you put some of your money into an investment that pays a fixed interest rate for 10 years, then, two years later, interest rates go up. The amount of interest you’re receiving won’t be adjusted to reflect the new, higher rates that would be available from interest-bearing investments on the current market.
Lastly, there’s credit risk, which is really just the answer to the following question: If an investor makes a loan or buys a bond, how likely is it that the borrower will pay the money back, with interest? If the risk of default—the borrower failing to pay back the loan—is high, the investor can expect to earn a better rate of return in exchange for taking on the extra risk. If the risk is low, the rate of return will normally also be lower.
Depending on the investment, any one of these risks, or all three, may be important, and they need to be balanced against potential income that you hope to earn.
Investors can use a number of different kinds of ETFs to try to generate income. Let’s start with bond ETFs. There are three types to consider:
- High yield bond ETFs typically seek to pay investors higher income in return for taking on greater credit risk. They are often issued by emerging or smaller companies, or firms that may have experienced financial difficulties and have lower credit ratings as a result.
- International bond ETFs focus on bonds issued outside the US, which may offer attractive yields compared to domestic bonds but also carry additional risks. These bonds may be issued by countries or, more commonly, by non-US firms.
- Tax-free municipal bonds provide potential income that is typically exempt from federal taxes and may also be exempt from state taxes if the investor lives in the state where the bond was issued.
An alternative to bond ETFs are equity income ETFs, which aim to generate income primarily by purchasing stocks that pay dividends. One popular type of equity income ETF, a high dividend ETF, focuses on companies that have paid high dividends. Another type concentrates on companies that may have higher-growth potential (along with higher risk) but also pay dividends, called dividend appreciation ETFs.
Ultimately, every investor who hopes to generate income from a portfolio has to choose which investments are right for them, but ETFs are one option. They can provide a wide variety of potential solutions for income seekers. The key is finding the ones that fit your time frame and goals and which carry risks that you’re comfortable taking. Please review these pages regarding ETFs to learn more about how ETFs work and what risks they involve.