Weighing the Risks: Junk Bond or Equity ETFs?

Yields on bonds keep sticking persistently to historic lows as stock volatility keeps bouncing around on global uncertainty, which has exchange-traded fund market participants wondering whether it’s better to get on the equity ETF train or hop into the long-running rally in junk bond ETFs.

News reports that yields in below-investment-grade, or junk, debt fell to record lows last week have market watchers speculating when the bottom will fall out of the market even as they admit that not many asset classes these days are offering junk’s 5% to 6% returns.

Dividend ETFs, meanwhile, are in favor because quality dividend ETFs help mitigate risk, said Tom Lydon, president of Global Trends Investments, in a comment Monday on ETFtrends.com.

“Many investors are using dividend ETFs as a way to dip a toe in the stock market with a more conservative strategy and income to boot,” Lydon wrote. “News over the weekend from Cyprus is a reminder of the macro risks still lingering in the market.”

So what’s an investor to do?

“The key is to build a portfolio with the bulk of your portfolio in core diversified asset classes, and then to explore more exotic ETFs,” said Michael Iachini, a director and ETF expert with Charles Schwab Investment Advisory, in an ETF call on Friday.

Schwab, which last month rolled out a commission-free ETF platform called OneSource, recommends a “core and explore” investment approach when constructing an ETF portfolio. Those core diversified asset classes that are suitable for long-term holdings include U.S. large and small cap stocks and broad international stocks, as well as U.S. investment-grade bonds and cash, Iachini said. The riskier “explore” ETFs include high-grade bonds, emerging markets, focused sectors, sovereigns and commodities.

“Don’t give an ETF a pass just because it’s non-core,” Iachini said, adding that investors should compare the exotics to one another. As for the choice between higher-yielding junk or equity, he noted that high-yield bond ETFs are equity-like in the way they move. “Investors are hungry for yield, and it gets tougher and tougher to capture yield without taking on risk.”

Meanwhile, ETF provider Global X Funds on March 4 released a study examining the performance and relative volatility of high dividend-paying stocks over time. In “High Dividends: Myth vs. Reality,” Global X reported that dividend-paying stocks repeatedly outperformed non-dividend payers over a period of 10 years.

Go to the next page for a breakdown on yields for the most popular high-dividend ETFs and junk bond ETFs.

“Conventional wisdom holds that higher dividends mean lower performance, but our research shows the exact opposite,” said Bruno del Ama, chief executive of Global X Funds, in a statement. ”We wanted to tackle the issue of dividends head on, and demonstrate to investors that high-yielding global dividend stocks may be an important part of a portfolio.”

The outperformance increases as the dividend yield increases, with the highest return for 10% to 17% dividend payers and the second highest return for dividend payers above 17%, according to the Global X’s study of various risk factors. The risk of dividend-paying stocks was lower than non-dividend paying stocks, and surprisingly, 6% to 10% dividend payers showed similar risk to 0% to 2% and 2% to 6% dividend payers.

“Interestingly, stocks in the dividend range of 10% to 17% are often not included in dividend indexes and funds,” the study concludes. “This lack of interest by the financial community creates a significant opportunity for investors.”