The Right Income Investments for Your Portfolio Now-Kiplinger

Cash in Hand


The Right Income Investments for Your Portfolio Now

Jeffrey R. Kosnett

For good yields, consider municipal bonds, energy pass-throughs and U.S. agency bonds.



My in-box is inundated with e-mails from readers wanting to know which of my previous income-oriented ideas remain valid. The answer: Depends on the subject. I continue to oppose long-term Treasury bonds, even more so now that yields have dropped about 0.6-percentage point over the past six weeks and have gone from merely low to ridiculously low.

But I’m as confident as ever that municipal bonds will provide secure interest payments. Income investments tied to energy are well priced now and are likely to boost their cash payouts. In sum, except for the miserable rates on money-market funds and other cash substitutes, conditions are decent for most of your income-oriented investments.

Municipal bonds are safe

Given the parlous condition of state and local finances, you might conclude that muni bonds are a disaster waiting to happen. I disagree.

In fact, I feel even more confident about most munis after doing some research into what causes them to blow up. In April, Moody’s Investors Service issued a summary of every default since 1970 by a municipal issuer with a Moody’s rating (that includes all state and local governments and most revenue-generating public authorities, so this isn’t a case of Moody’s stacking the deck by selecting only the highest-quality issuers). For all that time, Moody’s counted 54, or barely more than one a year. A default is any event that interrupts the timely payment of interest and principal or forces bondholders to take a “haircut” -- for example, having to accept a less valuable new bond in exchange for the original. The average loss of principal one month after these 54 incidents was 40%. Corporate-bond defaults, by comparison, typically cost bondholders 63%.

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The 39-year period in the Moody’s review had some recessions and real estate busts. Yet nearly every default resulted from insider malfeasance, botched low-income housing deals or the overexpansion of hospitals and other health-care businesses -- in other words, the causes were preventable. The economy was expanding rapidly when the largest-ever municipal bankruptcy t occurred. That was in 1994, when Orange County, Cal., fumbled a speculative interest-rate bet that resulted in $1.5 billion in losses. The county filed for bankruptcy but eventually made up the lost principal and interest.

At any rate, the economy seems to be recovering well enough that the finances of state and local governments have probably hit bottom. This ought to reassure you if you own or are considering high-quality municipals. You can get about 4% to 4.5% tax-free with high-quality munis maturing in 20 years, or you can get 5%-plus taxable if you choose Build America Bonds.

My suggestion: Stick with general-obligation bonds or revenue bonds tied to water, power, education and transportation projects. Skip hospital bonds and any bond backed by future retail and residential real estate development. Avoid high-yield municipal-bond funds, which often buy unrated issues. Then relax.

Green light for oil and gas

In the June issue of Kiplinger’s Personal Finance, you’ll find my annual survey of timely high-yielding investments. For years, one of the staples of the annual yieldfest has been a category known generically as energy pass-throughs, a group that includes master limited partnerships and royalty trusts. Both MLPs and trusts slumped with the recession, but they’re worthwhile again both for yield and for potential total return.

Royalty trusts and MLPs must distribute nearly all the income they produce. You buy and sell units just as you do shares of common stock, so these are the simplest and most liquid sources of current income from the production of oil and natural gas and from energy pipelines and storage. Dividends usually are part ordinary income and part tax-deferred return of capital; the proportion varies from year to year and from investment to investment.

I have two main strategies for these investments. One is to buy and hold them permanently, with the understanding that the amount of income they generate varies with the volume of the energy sold and its price -- in other words, roughly with the overall health of the economy. The other strategy is to buy when you can get a current yield of 8% or better, then lighten up on them or sell them entirely when the yield falls below 6%, whether because the share price appreciates or the distributions shrink. Because many of these trusts and MLPs do yield more than 8%, this is a good time to buy them.

As long as the price of oil remains above $60 a barrel (it’s about $70 now) and the volume of natural gas sold continues to rise, the better trusts should be able to maintain or increase their distributions. Among my favorite trusts: BP Prudhoe Bay Royalty Trust (symbol BPT) passes along the proceeds of pumping onshore Alaskan crude. At its May 19 closing price of $93.30, it yields 9.7%. (BPT is not related to BP itself.) Onshore gas producer San Juan Basin Royalty Trust (SJT), which closed at $22.75, yields 7.8%. And Hugoton Royalty Trust (HGT), which is similar to San Juan, yields 12.7% at its closing price of $18.56. Another idea is to choose among about a dozen MLPs that own pipelines and storage terminals instead of oil-and-gas reserves. These yield between 6% and 8% and are less likely to cut dividends if energy prices drop.

Alternatives to Treasury bonds

Finally, a word for Treasury-bond fans. You and I can’t do anything about the low yields, but if you want to own debt backed by the full faith and credit of the U.S. government, you can earn slightly more than the rate the Treasury pays by investing in government-agency securities. That means debt issued by the Federal Home Loan Banks, the Tennessee Valley Authority, the Government National Mortgage Association, and the now government-controlled Fannie Mae and Freddie Mac (I’m talking about Fannie’s and Freddie’s regular bonds, not the mortgage-backed securities). Take whatever the Treasury pays and add about 0.2 percentage point to the yield, or perhaps a little more than that with bonds from Fannie and Freddie (see Buy Agency Bonds). When rates are this low, every bit helps.



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