High-Yield Financial ETFs in a Rising Rate Environment: Navigating Income Generation and Risk

In an era of persistent inflation and aggressive monetary tightening, investors seeking income generation face a paradox: higher interest rates typically reduce the appeal of fixed-income assets while creating opportunities for certain equity-based strategies. High-yield financial ETFs, however, occupy a unique space in this landscape, offering a blend of equity exposure and income generation that can thrive-or falter-depending on structure and sectoral focus. This analysis examines their performance during recent Federal Reserve rate hikes (2022–2025) and historical cycles, drawing on empirical data to assess their viability as tools for income-focused portfolios.

The Dual Nature of High-Yield Financial ETFs

High-yield financial ETFs can be broadly categorized into two types: those focused on equity dividends and those leveraging bond-like structures. Equity-based funds, such as the Invesco KBW High Dividend Yield Financial ETF (KBWD), concentrate on financial stocks with strong dividend yields, particularly mortgage REITs and business development companies (BDCs), according to Morningstar's analysis. Bond-oriented strategies, like the VanEck CLO ETF (CLOI), invest in collateralized loan obligations, which often feature floating-rate structures that adjust with market conditions, as highlighted in a U.S. News slideshow.

During the 2022–2025 rate-hiking cycle, these ETFs exhibited divergent outcomes. KBWD, for instance, faced significant volatility due to its heavy exposure to mortgage REITs (44% of assets) and BDCs (36% of holdings), which are highly sensitive to interest rate changes, according to a Richiest analysis of bond ETFs and rising rates a Richiest article. Despite a trailing 12-month yield of 13.8%, the fund underperformed the S&P 500 and experienced sharp drawdowns, reflecting the fragility of leveraged, high-yield equities in a tightening monetary environment. Conversely, CLOI demonstrated resilience, rallying 7% in 2024 as demand for floating-rate, investment-grade CLOs grew amid inflationary pressures, a trend also noted by U.S. News. This contrast underscores the importance of structural design in determining performance.

Historical Context: Lessons from Past Cycles

Historical data from earlier rate-hiking periods (2000–2025) reveals patterns that align with these recent trends. Short-term and floating-rate bond ETFs, such as the iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) and the iShares Floating Rate Bond ETF (FLOT), consistently outperformed during rate hikes due to their low durations and ability to adjust to new interest rates, as observed in the U.S. News slideshow. For example, SHYG's focus on high-yield corporate bonds with maturities under five years minimized price sensitivity to rate increases, making it a preferred choice for income investors.

Equity-based financial ETFs, however, showed mixed results. The Financial Select Sector SPDR Fund (XLF), which tracks large-cap financial stocks, often outperformed during rate hikes due to its exposure to banks and insurers-sectors that benefit from higher net interest margins, according to Bankrate's list. In contrast, niche funds like the VanEck Mortgage REIT Income ETF (MORT) faced pronounced volatility. MORT, which focuses on mortgage REITs, delivered a -26.93% total return in 2022 but rebounded with a 14.75% return in 2023, illustrating the cyclical nature of such strategies, as Morningstar observed.

The Yield-Risk Trade-Off

High-yield ETFs often promise attractive income, but this comes with inherent risks. The Vanguard High Dividend Yield ETF (VYM), which blends large-cap equities with a focus on growth and value, achieved a 9.52% compound annual return over 30 years (1995–2025) but experienced a maximum drawdown of -51.79% during the 2008–2009 crisis, a performance item noted on Bankrate's list. This highlights the trade-off between yield and capital preservation: while high dividends can cushion losses during market downturns, they do not eliminate the risk of principal erosion.

For investors in rising rate environments, the key lies in balancing yield with duration and diversification. Floating-rate instruments, such as CLOI's collateralized loan obligations, offer a hedge against rate hikes by resetting coupons periodically, a structural benefit discussed in the U.S. News slideshow. Similarly, short-duration bond ETFs like SHYG mitigate price risk while maintaining income generation. In contrast, long-duration or leveraged strategies-such as those in KBWD-can amplify losses when rates rise, as seen in MORT's 2022 performance reported by Morningstar.

Strategic Implications for Investors

The performance of high-yield financial ETFs during recent rate hikes underscores the need for a nuanced approach. Investors should prioritize funds with structural advantages in rising rate environments, such as floating-rate or short-duration instruments. For example, CLOI's 6.4% net asset value (NAV) return in 2024 demonstrates the appeal of collateralized loan obligations as a source of stable income, a point highlighted in the Richiest article. Conversely, funds like KBWD, while offering high yields, require careful monitoring due to their concentration in volatile sectors.

Moreover, diversification across asset classes and sectors can mitigate risks. The Financial Select Sector SPDR Fund (XLF) and the Vanguard Value ETF (VTV) provide exposure to broader financial and value equities, which historically have shown resilience during rate hikes, as Bankrate observed. Combining these with bond-oriented strategies like SHYG or FLOT can create a balanced portfolio that capitalizes on both income and capital appreciation.

Conclusion

High-yield financial ETFs present a compelling but complex opportunity for income generation in a rising rate environment. Their performance hinges on structural design, sectoral exposure, and macroeconomic conditions. While equity-based funds like KBWD and MORT offer attractive yields, they come with heightened volatility. Bond-oriented strategies, particularly those with floating-rate or short-duration characteristics, provide a more stable alternative. As the Federal Reserve continues to navigate inflation and economic uncertainty, investors must weigh yield potential against risk profiles, ensuring their portfolios remain aligned with both income goals and capital preservation.