By WallStreetDaily.com

By Martin Hutchinson, Global Markets Analyst

The recent explosion of exchange-traded funds (ETFs) has provided income investors with many new ways of goosing returns.

However, the ETFs with the juiciest yields can be quite dangerous, as they’re vulnerable to dividend cuts and capital erosion.

Thus, I decided to sort through the universe of high-dividend ETFs and identify those that are both sound and attractive income-boosters – as well as those that are dangerous value traps.

High Risk, High Reward?

The highest-yielding income ETFs specialize in mortgage real estate investment trusts (mREITs). These mREITs invest in residential and commercial mortgages, generally leveraging themselves to do so, and then pay high dividends from the income they generate.

The problem is that rising interest rates can hurt mREITs in three different ways.

First, rising rates reduce the “gap” between fixed rate mortgage receipts and funding costs, thus reducing returns as well as the dividends that the trust can pay.

Second, higher rates reduce an mREIT’s capital value, as the mortgages it holds decline in value.

Finally, if rates rise rapidly, they may produce a wave of mortgage defaults, as the underlying real estate gets into trouble.

Still, if you think rates aren’t going to rise much, an ETF like the iShares Mortgage Real Estate Capped ETF (REM) can offer value.

This $950 million ETF tracks the FTSE NAREIT All Mortgage Capped Index. And even if its 14.8% yield declines a bit – the yield would be 10.8% based on the most recent quarter – it would still be pretty succulent.

These Aren’t the Dividends You’re Looking For

In addition to mREITs, energy master limited partnerships (MLPs) also offer appetizing yields. But there are also plenty of risks here, as well.

Even natural gas MLPs – which may seem less risky, as natural gas prices haven’t cratered quite like oil – are a risky proposition. Many of the underlying companies are running at losses, so an ETF covering them is in severe danger of dividend reductions.

Thus, I wouldn’t recommend investing in MLP ETFs.

You’d do better to invest in a single refinery MLP such as Northern Tier Energy LP (NTI), which currently yields 15.7%. Refinery MLPs benefit from lower oil prices, so their dividends are especially attractive right now. Unfortunately, there aren’t enough of them to be combined into an ETF.

Let’s Get BIZD

Next up are business development companies, which make mezzanine and other subordinated debt investments in middle market companies.

The Market Vectors BDC Income ETF (BIZD), which tracks the Market Vectors U.S. Business Development Companies Index, yields 9.2% based on the last four quarters of dividends and 7.7% based on the latest dividend.

However, BIZD has lost 15% of its value since its inauguration in February 2013. With a $79 million market cap, it’s also rather small.

Overall, the principal risk in BIZD is less than that of mREIT ETFs and energy MLP ETFs – but there’s no question this sector could get in trouble in a recession. Even in normal times, it’s subject to mild erosion of principal, as are the underlying BDCs.

Another popular income investment is shipping, and the Claymore/Delta Shipping ETF (SEA) offers exposure to this industry. SEA, a $130 million fund, tracks the Delta Global Shipping Index. The problem is that the dividends jump about. The last dividend was $0.24, good for a 6.6% yield, but the one before was $0.67, and the three before that were all below $0.20.

SEA’s share price also gets in trouble in shipping crises – it dropped by nearly half in 2011 – but overall, this would seem to be a good bet for modest exposure to shipping with decent income potential.

Finally, the highest-yielding general dividend ETF is the Global X SuperDividend U.S. ETF (DIV), a $275 million fund that attempts to match the INDXX SuperDividend U.S. Low Volatility Index.

DIV pays dividends monthly, which can be an additional attraction. And while its dividends fluctuate, they do so only modestly. Based on the last four quarters of dividends, DIV yields 7.5%.

This fund has maintained its value over its two years of life and would seem to be a lower-risk alternative to some of the higher-yielding ETFs that still provides an attractive yield.

Bang for Your Buck

When combined with blue chips yielding the usual 2% to 4%, these high-yield ETFs can provide an attractive overall yield without too much capital risk.

Certainly the risks of a mixed portfolio of income ETFs would be less than a portfolio of junk bonds, which will all tend to get in trouble simultaneously in a recession.

Finally, bear in mind that ETF liquidity is untested in a recession. The share prices of some ETFs may vary substantially from the underlying value of their investments, in which case you should wait for the market to stabilize before selling.

Good investing,

Martin Hutchinson

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