ETFs for Income Investors

Exchange-traded funds charge low fees, offer instant liquidity and keep your tax bill down because they rarely distribute short-term capital gains. Income investors now have reason to cheer because of the proliferation of bond and dividend-oriented ETFs.

The count of bond ETFs nearly doubled last year, from 55 to 100, bringing competition to all the main fixed-income categories. Bond powerhouse Pimco entered the ETF business last June and now has a lineup of seven income ETFs. Vanguard, which is increasingly becoming Pimco’s arch rival (at least in the fixed-income arena), launched eight bond ETFs a few weeks later.

Sponsors are also forming more ETFs to pay dividends from real estate, energy and utilities. Last year saw the first exchange-traded portfolio of master limited partnerships, JPMorgan Alerian MLP Index (symbol AMJ). It mimics an index of 50 MLPs that pass on regular income from production, pipelines, tankers and oil and gas wells. (Names and historical data for the components of the index are available at www.alerian.com.) Natural gas has been a lousy investment of late, but if energy prices spiral up -- always a possibility -- so will the dividends. So far, AMJ has handed out a regular quarterly dividend of 44 cents a share, while its price has appreciated from $22.51 at its opening on June 2 to $29.15 today. The ETF’s current yield is 6.3% (all prices and yields are through the close on January 28).

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ETFs’ low expenses are especially helpful in the low-yield world of bonds. MarketVectors High-Yield Muni (HYD), which owns lower-quality, higher-yielding tax-exempt bonds, sports an annual expense ratio of 0.35%. The average open-end high-yield muni fund charges 1.12% a year -- and there are few no-load funds in that category.

Besides low expenses, a reliable income ETF should distribute dividends monthly and stick to the class of investments its name describes. It should also own at least 50 different bonds so that you are adequately diversified against a default or a series of downgrades.

But bond ETFs can’t do it all. If you’re interested in a flexible bond fund whose managers often change direction in search of high total returns, such open-end funds as Loomis-Sayles Bond (LSBRX), Fidelity Strategic Income (FSICX) and Pimco Unconstrained Bond (PUBDX) have no ETF counterparts.

And ETFs will have trouble keeping up with actively managed funds in strong years. For example, in 2009, the best-known ETF for investment-grade corporate bonds, iShares iBoxx $ Investment Grade Corporate (LQD), lagged most of its rivals because managers of actively run funds were able to take advantage of the wide array of opportunities in the high-grade corporate sector. Their successful bond picks more than made up for their higher expenses., however, has done just fine over the past three and five years (its annualized returns were 5.3% and 3.9%, respectively), and the ETF is a sound choice -- especially for investors who need monthly income. The fund currently yields 4.8%.

Notable newcomers

Six income ETFs stand out in the class of 2009. I generally prefer to refer to ETFs by their symbol rather than recall their lengthy official names:

AMJ, or JPMorgan Alerian MLP Index. As I described above, this ETF invests in 50 master limited partnerships that pass through income from storing, carrying or shipping oil and gas. With a yield of 6.3%, AMJ is one of the better income opportunities right now because junk bonds and emerging-markets debt have become expensive. The fund’s annual expense ratio is 0.85%.

ISHG, or iShares S&P/Citi 1-3 Year International Treasury Bond, owns short-term government bonds from Canada, Europe and Japan. It yields just 0.9%, but if you want to spread some cash around the euro zone and elsewhere to hedge against a falling U.S. dollar, it’s safe and convenient. Expenses are 0.35%.

IGOV, or iShares S&P/Citi International Treasury Bond, is the longer-maturity edition of ISHG. It yields 2.1% and offers both diversification and, in the future, a chance to buy the highest-quality foreign bonds when global interest rates are well above where they are now. . Fees total 0.35% a year. This is a good tool to keep in reserve.

ITR, or SPDR Barclays Capital Intermediate Term Credit Bond, buys investment-grade U.S. bonds with medium maturities. Expenses are just 0.15% and the fund yields 3.4%.

LWC, or SPDR Barclays Capital Long Term Credit Bond, is similar to ITR but with a much longer average maturity. That explains the high current yield of 5.9%. Expenses are 0.15%. However, you don’t want to be holding LWC when rates rise; it will take a big hit. (Bond prices move inversely with yields, and the longer the maturity the bigger the move.)

ZROZ, or Pimco 25+ Zero Coupon U.S. Treasury Fund (get the symbol?). With rates as low as they are, I wouldn’t fool with this one now. But some day, when rates are much higher than they are today, ZROZ will be a great tool for locking in those high rates or for betting on a nice capital gain when rates subsequently drop. The annual fee is 0.20%. I don’t mean to shrug off the other Pimco ETFs, but ZROZ is original and gutsy, whereas the others are just “me, too” funds.