Income Investor: my first foray into European ETFs

As a result of the rather freakishly high returns on my real-life DIY Income Investor portfolio in 2012 (and, pleasantly, continuing into the New Year!) I have decided to diversify a bit more outside the UK.

Act of faith

I continue to believe that most income investors should concentrate on their home currency – this income will pay the bills, without taking on additional currency risks. In any case, many of the shares and fixed-income securities quoted on the London Stock Exchange have extensive international exposure. Having said that, putting all your money in a single market is an act of faith in government – and the politicians in this country (and most countries, it has to be said) don’t seem to be able to deal effectively with the highest national debts in history.

The problem with going international is that it is administratively a bit difficult to do on a DIY basis – particularly in relation to recovering tax levied locally. Plus it is probably impossible for a DIY investor to try to follow in any detail the gyrations of more than one stock market. So I'm buying into a couple of high-yield exchange traded funds (ETFs), which do the admin for you, as well as diversifying. However, there is a cost: they take their cut (modest though it is, compared to most mainstream ‘funds’) and the yields on offer are only around the average of the portfolio.

ETFs are (generally) transparent, cost-efficient, liquid vehicles that trade on stock exchanges like normal securities. I have held a couple of UK-oriented income ETFs for a while: IUKD (which invests in high-yield shares) and ISXF (non-financial corporate bonds). Both have behaved as expected (with current yields around 5% and showing modest capital gains) although there are methodological concerns over IUKD, which was badly hit by the dividend-cutting aftermath of the 2008 crash.

Banking a bit on Banco

I have started my geographical diversification in Europe. My high-yield portfolio is split 50%/50% between dividend shares and fixed-income, and I propose to continue this allocation approach. There are many exotic varieties of ETF but the only ones I plan to invest in are those that deal in high-yield shares or corporate bonds and which invest in physical securities (ie, as opposed to ‘synthetic’ ETFs), following a specific index – hoping that this will prove more resilient in the next market meltdown.

The first is the iShares EURO STOXX Select Dividend 30 ETF (IDVY) which aims to closely track the performance of the named index, offering exposure to the 30 highest dividend-paying eurozone stocks from each country out of the EURO STOXX® Index. Companies included have a non-negative historical five-year dividend-per-share growth rate and a dividend to earnings-per-share ratio of less than or equal to 60%. The index is weighted according to net dividend yield. The biggest holding is...Banco Santander! So that sets the risk level pretty high!

The distribution yield is currently 5.85% and income is paid every quarter - but this is in euros, although the ETF is priced in GBP (pounds sterling) on the London Stock Exchange (LSE). Of course, you have to pay for this service but the total expense ratio (TER) is only 0.4%, much lower than traditional 'funds' that have provided such investment opportunities in the past.

Matching pair

My second European ETF purchase completes this matching pair, complementing the high-yield dividend ETF with a high-yield corporate bond ETF, specifically the iShares Markit iBoxx Euro High Yield Bond ETF (IHYG) . This ETF aims to closely track the performance of the eponymous index, comprising the ‘largest and most liquid fixed and floating rate sub-investment grade corporate bonds issued by both eurozone and non-eurozone issuers’. Only euro-denominated bonds with a minimum amount outstanding of €250 million are included in the index. For diversification purposes the weight of each issuer and country in the index is capped at 3% and 20% respectively. All bonds in the index are rated sub-investment grade - so this is also risky: largest holding (of 306!) - Banco Espirito Santo of Portugal...

This ETF is actually priced in euros on the LSE, which underlines the currency risk that I am adding to what are already risky assets. The total expense ratio is 0.5% and income is distributed half-yearly.

Risky?

Now, this is probably not the best time to be buying corporate bonds, given the on-going 'bubble' in fixed-income but the flat yield is still nearly 6.3% and the yield to maturity is over 5%. So, not brilliant timing, but not too poor a yield. Whether this yield is adequate for the risk remains to be seen.

(Note: the fact that these are all iShares ETFs is accidental. These seemed to be the easiest to find and buy electronically: there are others that will do a similar job.)

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