Over the past two years, many high-yield dividend stocks have fallen as interest rates rose. As risk-free CDs, Treasury bonds and high-yield savings accounts delivered returns of around 5%, dividend-paying stocks and exchange-traded funds (ETFs) lost their luster.
But in September the US Federal Reserve cut interest rates for the first time in four years. The country is also expected to make more rate cuts in the future as inflation cools. The yield on ten-year government bonds has already fallen to around 4% at the time of writing, and is likely to fall further in the coming quarters.
To take advantage of this trend, investors should once again buy high-yield dividend stocks and ETFs. So today, let’s take a look at two covered call ETFs and two municipal bond ETFs that you can consider adding to your portfolio to generate more passive income.
Buy these two covered call ETFs
Many high-yield ETFs sell covered call options to boost their returns. A covered call is a call option written on a stock you already own. When you sell the call, you earn a premium, while the buyer gets the opportunity to buy your shares at the strike price at expiration.
If the share does not reach the strike price on that date, you keep the premium and your share. But if the stock exceeds the strike price, you must sell it to the call holder unless you buy back the option at a loss.
ETFs using this strategy continually write covered calls on the stocks they own and use the premiums to boost their returns. When the underlying shares are called away, they buy them back at higher prices to write more covered calls.
This strategy works well in a bearish or stagnant market because the covered calls will consistently expire and the fund does not have to keep repurchasing the underlying securities. But in a bull market, covered call ETFs tend to underperform the major indexes because strike prices will continually limit the upside potential of the underlying securities.
Constantly writing covered calls is also not a tax-effective strategy because the seller books the premiums as capital gains upon expiration of each option. To simplify that process and reduce those taxes, some ETFs will trade equity-linked notes (ELNs), which are tied to covered calls, rather than writing and selling the options directly.
If this conservative income-generating strategy sounds attractive, you should buy these two high-yield ETFs: JPMorgan Equity Premium Income ETF (NYSEMKT: JEPI) And JPMorgan Nasdaq Equity Premium Income ETF (NASDAQ: JEPQ). Both ETFs use ELNs tied to covered calls while charging low expense ratios of 0.35%.
The JPMorgan Equity Premium Income ETF has a diverse portfolio of 134 stocks and writes monthly calls on the S&P500. The JPMorgan Nasdaq Equity Premium Income ETF holds 98 stocks and issues monthly calls on the Nasdaq-100.
Both ETFs pay monthly dividends, which come from a combination of the dividends generated by their underlying securities and the covered calls. The Premium Income ETF pays a 30-day SEC yield of 8%, while the Nasdaq Equity Premium version pays a yield of 12.4%. The Nasdaq version pays a higher return because the covered calls are tied to more volatile (and therefore higher-yielding) stocks. But at the time of writing, they are also both trading at or near their net asset value (NAV).
Buy these two municipal bond ETFs
Municipal bonds are another good option for generating passive income for two reasons. First, their dividends cannot be taxed at the federal level. They also cannot be taxed at the state level if you live in the state that issued the bonds. So for residents of states without any income taxes, all of that income is exempt from taxes.
Second, municipal bonds are generally a lot safer than corporate bonds. But purchasing individual municipal bonds can often be a complicated and confusing process. To address these challenges, many asset managers are bundling large baskets of municipal bonds into ETFs. Two of those popular funds are the VanEck High Yield Muni ETF (NYSEMKT: HYD) and the BlackRock High Yield Muni Income Active ETF (NYSEMKT: HYMU).
VanEck’s ETF owns 1,472 municipal bonds, has a low expense ratio of 0.32% and has a 30-day SEC yield of 4.2%. BlackRock’s ETF holds a smaller basket of 321 municipal bonds and has a slightly higher expense ratio of 0.35%, but has a higher 30-day SEC yield of 4.3%. Both ETFs trade near their NAV prices.
With a tax-free yield of over 4%, these low-risk municipal bond ETFs will become even more attractive as interest rates fall. They won’t outperform the market or impress more aggressive income investors, but they can be great options for retirees who simply want to passively generate some tax-free income with minimal volatility.
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Leo Sun has positions in JPMorgan Equity Premium Income ETF and JPMorgan Nasdaq Equity Premium Income ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
4 High-Yield Dividend ETFs to Buy to Generate Passive Income was originally published by The Motley Fool
