Many investors use exchange-traded funds (ETFs) to get well-diversified, low-cost access to broad indexes of stocks or bonds, in order to fill gaps in their portfolios or take advantage of shorter-term market opportunities. ETFs can also be useful to investors seeking a stream of income. Given the low yields on so many investments at the moment, income-focused investors may want to consider every tool at their disposal to generate cash flow, and ETFs are a dynamic tool.

Fixed-income ETFs

When most investors think about income investments, they think about bonds or CD’s. Most bonds have a coupon, which means that they will distribute interest payments to their holders on a regular basis (often twice a year).

The downside of holding individual bonds, especially corporate bonds, is the risk of default—the company that issued the bond might not be able to pay it back. One way to mitigate this risk is diversification—spreading your assets among a lot of different bond issuers. ETFs excel at diversification, because when you own an ETF you own a fractional share of a pool containing lots of different securities. It’s important to keep in mind that the value of a bond ETF will go up and down with the value of the underlying bonds in the portfolio, and it does not have a fixed maturity date like individual bonds do. As bonds in the portfolio mature, the ETF manager will reinvest the proceeds into other bonds. The exception is target maturity date bond ETFs, where the fund will close and liquidate on a set date (the year the underlying bonds all mature).

Many investors use exchange-traded funds (ETFs) to get well-diversified, low-cost access to broad indexes of stocks or bonds, in order to fill gaps in their portfolios or take advantage of shorter-term market opportunities. ETFs can also be useful to investors seeking a stream of income.

Given the low yields on so many investments at the moment, income-focused investors may want to consider every tool at their disposal to generate cash flow, and ETFs are a dynamic tool.

When most investors think about income investments, they think about bonds (the primary example of a fixed-income instrument). Most bonds have a coupon, which means that they will distribute interest payments to their holders on a regular basis (often twice a year).

The downside of holding individual bonds, especially corporate bonds, is the risk of default—the company that issued the bond might not be able to pay it back.

One way to mitigate this risk is diversification. ETFs excel at diversification, because when you own an ETF you own a fractional share of a pool containing lots of different securities. It’s important to keep in mind that the value of a bond ETF will go up and down with the value of the underlying bonds in the portfolio, and it does not have a fixed maturity date like individual bonds do. As bonds in the portfolio mature, the ETF manager will reinvest the proceeds into other bonds. The exception is target maturity date bond ETFs, where the fund will close and liquidate on a set date (the year the underlying bonds all mature).

Below are various types of fixed-income ETFs you might consider for your income-focused portfolio.

• Treasury bond ETFs. Yields on Treasury bonds are near historic lows at the moment, making these ETFs less attractive for income-sensitive investors. However, the essentially nonexistent risk of default on Treasury bonds still makes them an important piece of a portfolio.

• Treasury Inflation-Protected Securities (TIPS) ETFs. TIPS pay low coupons, but their face values go up as inflation increases. The low coupons make them less attractive for most income-focused investors, but those concerned about inflation may still want to consider TIPS.

• Investment-grade corporate bond ETFs. These funds invest in bonds issued by companies with good credit ratings, which are seen as unlikely to default. Investment-grade corporates are somewhat riskier than Treasury bonds, but they generally pay higher interest.

• Municipal bond ETFs. If you are in a high tax bracket and you’re investing in a taxable account, be sure to consider municipal bond ETFs. These funds produce income that is generally free from federal income tax and even, in some cases, free from state income tax. If you expect to be subject to the alternative minimum tax (AMT), take a look at funds that track AMT-free indexes. Note that the yields on municipal bonds tend to be lower than taxable bonds, but the tax benefits may make them more attractive on an after-tax basis.

Stan Evans is a fee-based financial planner and registered investment advisor. He can be contacted at 740-682-0012; stan@stanevansfinancialplanning.com. His website is www.stanevansfinancialplanning.com.