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All Contents © 2016The Kiplinger Washington Editors
It used to be easy to earn generous income safely from your investments: Buy Treasury bonds or certificates of deposit and watch the cash roll in. But with yields on low-risk investments scraping rock-bottom and higher interest rates nowhere in sight, retirees and other income-oriented investors must grapple with an unsettling question: Should you play it safe and accept microscopic yields or take calculated risks to get more? “In this environment you have to take on more risk to get any given amount of yield,” says Jay Wong, comanager of Payden Equity Income Fund.
In other words, land mines abound. If rates start to rise quickly, some income investments will get pummeled. If they don’t rise at all—possibly a sign of a weak economy—other investments could suffer. Plus, little is cheap today. Says Andy McCormick, head of T. Rowe Price’s taxable U.S. bond team: “You go through cycles when it’s appropriate to play offense. Other times, you play defense. This is a moment when you have to play both sides of the ball.”
This treacherous environment demands that you understand your alternatives and know what could go wrong. Here are some of the best options for income seekers, listed roughly in order of yield and risk (from lowest to highest).
By Carolyn Bigda, Contributing Writer
By Kathy Kristof, Contributing Editor
, Originally published May 2015
Don’t be put off by these seemingly low yields. Interest from muni bonds is exempt from federal taxes. And if you buy munis issued by your home state, they’re also likely to be free of state taxes (and possibly local income taxes, too). With the top federal tax bracket at 39.6% and investment income for high earners subject to a 3.8% excise tax under the Affordable Care Act, even a modest yield on a tax-free investment looks pretty good, says Marilyn Cohen, CEO of Envision Capital Management, in El Segundo, Calif.
Consider a high-quality muni bond maturing in 10 years and yielding 3%. For top earners, that’s the equivalent of 5.3% from a taxable bond, and it’s way above the 1.9% yield of a 10-year Treasury bond. But avoid munis if you’re in a lower tax bracket or investing through tax-favored retirement plans. Retirees should also know that although the interest earned on munis is not taxed by Uncle Sam, it’s added in when you calculate your modified adjusted gross income, which the IRS uses to determine how much of your Social Security income is taxable. Thus, muni interest could subject more of your Social Security benefits to taxes.
What could go wrong: Defaults are rare, but the finances of some states and municipalities are wobbly. Some cities could even file for bankruptcy. Rising interest rates would also cause the value of existing bonds to fall. That’s not a problem if you own individual bonds and hold to maturity. For those investors, the biggest risk is inflation, which eats into the value of your principal and the fixed stream of interest payments.
Next slide: Our picks for municipal bonds.
Avoid sketchy issuers, and keep bond maturities relatively short to dampen the impact of rising rates. For those living in high-tax states, such as California, New York and New Jersey, it makes sense to stick with bonds issued by your state of residence or state-specific bond funds. California residents should consider T. Rowe Price California Tax-Free Bond (symbol PRXCX), which yields 2.0%. That’s the equivalent of a taxable 4.0% for the highest-income Californian. The fund’s average maturity—17 years—is on the high side. But its average duration, a measure of interest-rate sensitivity, is a tolerable 5.0 years (the figure suggests that if rates were to rise by one percentage point, the fund’s share price would drop by 5.0%).
If state taxes aren’t a big issue, you may do better by buying a multistate muni fund. For example, Vanguard Long-Term Tax-Exempt Investor (VWLTX), with an average duration of 6.0 years, yields 2.2%. That’s the equivalent of 3.9% for someone in the highest tax bracket and a respectable 3.1% even for someone with a marginal tax rate of 28%.
Prefer individual bonds? Recently, a California Department of Veterans Affairs bond, rated double-A, yielded 2.9% to maturity in 2025. And a New York City Housing Development Corp. bond, rated double-A-plus, yielded 2.6% to maturity in 2024.
Investment-grade corporate bonds yield more than Treasuries of comparable maturity but carry only slightly more risk. And because of their higher interest payments, corporates hold their value better than Treasuries when interest rates rise.
What could go wrong: Although the default rate on high-quality corporate bonds is low, companies can—and do—go bankrupt. Moreover, if rates rise sharply, prices of corporate debt will fall.
Next slide: Our picks for investment-grade corporate bonds.
To get decent yield without taking on too much interest-rate risk, look for intermediate-term bond funds and individual corporates with maturities of three to 10 years.
Consider, for example, two bonds with triple-B-minus ratings, the lowest investment-grade ranking. One, from private-label credit card issuer Synchrony Financial (SYF), yields 2.5% to maturity in February 2020. Synchrony, which is being spun off from General Electric this year, has a strong business. The other bond, from Expedia (EXPE), the popular online travel site, yields 3.4% to maturity in August 2020. Expedia is growing through acquisitions, most recently with its announced purchase of competitors Orbitz and Travelocity.
A good place for fund investors to start is Vanguard Intermediate-Term Investment-Grade Investor (VFICX). The fund, which yields 2.4%, has about three-fourths of its assets in corporate bonds, with the rest in Treasuries and asset-backed securities. Manager Gregory Nassour emphasizes quality. More than 75% of assets are in debt rated single-A or higher, compared with 45% for the average corporate bond fund. The fund’s average duration is 5.4 years, and expenses are a modest 0.20% of assets annually.
Fidelity Total Bond (FTBFX), a member of the Kiplinger 25, is a bit more aggressive. It owns mostly Treasuries and highly rated corporate bonds, but it also has a smattering of junk corporate bonds and emerging-markets debt. The fund yields 2.4% and has an average duration of 5.1 years. Annual expenses are 0.45%.
Interest rates on floating-rate loans, essentially IOUs that banks make to borrowers with below-investment-grade ratings, are tied to a short-term benchmark and reset every 30 to 90 days. That makes these loans a good place to be if interest rates rise. You earn a decent yield because of the lower quality of the borrowers. But the loans tend to be less volatile than junk bonds because banks have priority over other lenders should the borrower default and because the frequent interest-rate resets protect the lender from a rise in rates.
What could go wrong: The bank loan market is relatively small, so if investors get spooked, bank loans can suffer. In 2008, the average floating-rate bond fund dropped 30%. Looking ahead, bank loan returns will likely be anemic if the Federal Reserve continues to put off raising short-term rates. And most bank loans have a rate “floor,” or a minimum interest rate. So even if short-term rates rise, it could take a few rate hikes by the Fed before floating-rate loans see the benefit, says Anthony Valeri, a strategist at LPL Financial, a brokerage.
Next slide: Our picks for floating-rate loans.
This category is best left to professionals. Uncertainty about the Fed may lead investors to pull money out of bank loans, so stick with loans of high quality. Our favorite bank-loan fund is Fidelity Floating Rate High Income (FFRHX). The fund mostly holds loans rated double-B or single-B, the two highest tiers of junk bond territory. It charges 0.69% annually and yields 4.0%.
Banks pay almost nothing today, but a few offer generous returns if you follow certain rules.
What could go wrong: Higher-yielding accounts require that you either leave your money alone for a set period or make specific transactions regularly, such as debit card purchases or direct deposits. Fail to meet those terms and the yield shrinks.
Next slide: Our picks at the bank.
The highest-yielding CDs require that you commit your money for five years and typically charge a six- to 12-month interest penalty if you cash out early. But Allan Roth, a financial planner in Colorado Springs, Colo., says a five-year CD can make sense even if you stay put for just a year. Barclays, for example, recently offered a five-year CD that yielded 2.25%, with a six-month early-withdrawal penalty. If you cash out after one year, your effective annual yield is still 1.13%. After two years, the payout climbs to 1.69% and continues to rise each of the remaining three years. “Just think of it as a one-year CD that gives you a bonus if rates don’t rise,” Roth says.
High-yield checking accounts are another option. These products, available at regional banks and credit unions, pay as much as 5%. One good deal relative to its requirements is Max Checking at Lake Michigan Credit Union. It yields 3% on balances of up to $15,000. To qualify, each month you must make at least one direct deposit and 10 debit-card purchases, and you must log in to online banking four times. Plus, you must receive statements electronically. To find local deals, go to DepositAccounts.com.
Preferred stocks straddle the gap between stocks and bonds. They trade like stocks, usually near their issue price (generally $25 a share). But they pay fixed dividends and can be “called”—redeemed by the issuer—at set intervals. Payments from many preferreds are considered “qualified dividends” and receive favorable tax treatment; most people pay just 15% to Uncle Sam on their preferred payouts. Unlike bonds, which mature on specified dates, most preferreds have no set repayment date.
What could go wrong:
If an issuer gets into trouble, it could suspend preferred dividends. Moreover, as with bonds, prices of preferreds move in the opposite direction of interest rates. And because preferreds have distant maturity dates, if they mature at all, they are especially vulnerable to higher rates. For now, don’t expect the Fed to hike short-term rates more
than once or twice this year. And low oil prices and a strong dollar are likely to keep a lid on long-term rates.
Next slide: Our picks for preferred stocks.
You can buy a diversified basket of preferred shares through low-cost exchange-traded funds, such as iShares U.S. Preferred Stock ETF (PFF, yield 5.5%) and PowerShares Preferred Portfolio (PGX, yield 5.9%).
If you prefer to own individual issues, stick with strong firms and avoid paying much more than a stock’s “par” value of $25. For example, Wells Fargo Series N (WFC-PN) trades for just under $25 and yields 5.3%. The bank may redeem the issue at $25 starting in 2017. This preferred’s payouts do not qualify for favorable tax treatment. One whose dividends do qualify is Metlife’s 6.50% Non-cumulative Preferred Stock Series B (MET-PB). At a bit less than $26, the stock yields 6.3%. But MetLife can redeem the issue at any time for $25 (a right the company has had since 2010).
The U.S. market may not be a bargain, but a lot of stocks sport dividend yields that beat the pants off Treasury bonds. The economy is growing nicely, and many companies are loaded with cash, so it’s not hard to find firms that pay well today and are likely to boost their dividends in the future.
What could go wrong: Well, we’re talking about stocks, so risks abound. A company’s results could fall short of estimates; an entire industry (think coal) may go out of favor; or the economy could sour, dragging down most stocks. And, of course, dividend payments are not guaranteed.
Next slide: Our picks for dividend-paying stocks.
You can find plenty of good funds that focus on dividends. Start with Vanguard Dividend Growth (VDIGX), a member of the Kiplinger 25. As its name suggests, the fund focuses on companies that manager Don Kilbride believes will continue to boost their payouts. Biggest holdings at last report were United Parcel Service, UnitedHealth Group and insurer ACE Ltd. The fund yields 2.0%. For more income, consider Schwab U.S. Dividend Equity ETF (SCHD), which yields 2.9%. Although the ETF owns dividend growers, its main emphasis is on stocks with steady records of paying dividends; its biggest holdings are Chevron, Home Depot and Intel.
But Josh Peters, editor of the Morningstar DividendInvestor newsletter, says it’s not hard for investors to identify solid individual dividend payers themselves. “You don’t necessarily need to be a pro to own Johnson & Johnson or General Electric,” he says. In fact, General Electric (GE, $25, yield 3.7%) is a favorite of his. The company has been restructuring to return to its industrial roots, and the stock, which fetched more than $60 in 2000, is cheap, Peters says.
Also appealing are stocks in two widely dissimilar industries: American Electric Power (AEP, $56, 3.8%), a Columbus, Ohio–based utility that delivers electricity in 11 states, and Ford Motor (F, $16, 3.7%), which is benefiting from surging auto sales.
Another fertile area for dividends is property-owning real estate investment trusts. REITs don’t have to pay income taxes on their profits as long as they pass at least 90% of them on to shareholders each year. Not only do REITs deliver above-average yields, they help diversify a portfolio because they often move out of sync with the rest of the stock market. Marilyn Cohen, CEO of Envision Capital Management, recommends Government Properties Income Trust (GOV, $23, 7.5%), which buys buildings and leases them out to federal and state governments. She also likes BioMed Realty Trust (BMR, $23, 4.6%), because it mainly leases space for labs and other scientific work to the drug and biotech industry. The spaces are so specialized that tenants rarely move, she says.
Finally, if you think oil prices have stopped falling, you’ll earn a decent current return—and probably some capital gains—by investing in an energy giant. And even if oil prices go lower, none of these companies is going away: Chevron (CVX, $105, 4.1%), ConocoPhillips (COP, $62, 4.7%), ExxonMobil (XOM, $85, 3.2%) and Occidental Petroleum (OXY, $73, 3.9%).
Though master limited partnerships trade like stocks, these securities have unique tax benefits that allow them to “pass through” all their income to investors, without paying corporate taxes. That generally results in solid yields.
What could go wrong: Special tax treatment for MLPs is specifically designed to help foster energy infrastructure in the U.S., so most partnerships are tied to the oil-and-gas industry. Not surprisingly, MLP share prices fell sharply as oil prices crashed over the past year. From its peak last August 29 through its January 13 low, the Alerian MLP index surrendered 21%. Hardest hit were MLPs that generate their income from exploration for and production of oil and gas. Keep in mind, too, that if you invest in an MLP, you’ll have to contend with a K-1 partnership form come tax time.
Next slide: Our picks for energy MLPs.
Investing in Energy MLPs requires care. For starters, avoid funds that focus on MLPs. They lose the pass-through benefits that individual MLPs enjoy. As for individual firms, Kiplinger’s columnist Jeffrey Kosnett focuses on safety, so he prefers MLPs that “move, process and store all the oil and gas that drivers and everyone else will continue to consume.” His favorites: Enterprise Products Partners (EPD, $33, 4.5%), Magellan Midstream Partners (MMP, $77, 3.6%) and Plains All American Pipeline (PAA, $49, 5.5%).
Tim Plaehn, analyst for income investing at Investors Alley, a research service, likes Plains, too. He also favors so-called logistics MLPs, which provide services that facilitate the movement of crude oil and refined products. His recommendations: Delek Logistics (DKL, $44, 4.7%), PBF Logistics (PBFX, $23, 5.8%) and Western Refining Logistics (WNRL, $29, 4.6%). For a mega-yield, Plaehn suggests Oneok Partners (OKS, $41, 7.7%), which gathers, processes, stores and transports natural gas.
Like ETFs, closed-end funds invest in a package of securities and then trade like stocks. Unlike ETFs, closed-ends don’t have mechanisms designed to ensure that their share prices closely track the value of the funds’ assets, or net asset value (NAV). So it’s not uncommon for a closed-end’s share price to trade for a significant premium to (or discount from) its NAV. Clever investors try to take advantage of these pricing anomalies by buying closed-ends when they trade at big discounts and selling when the discount narrows or turns into a premium.
What could go wrong: Quite a bit. The securities the fund owns may head south. You may buy a fund at a discount to NAV, then see the discount get wider. Or you may be willing to buy what you think is an exceptional closed-end at a premium to NAV, only to see the price swing to a discount. Moreover, closed-ends, especially those that own bonds, often borrow money to improve their results. But leverage works both ways and can decimate returns if the market turns against you. With closed-ends, “the highs are higher and the lows are lower,” says Morningstar analyst Cara Esser.
Next slide: Our picks for closed-end funds.
Bill Gross may have left Pimco, but the firm still offers plenty of superb closed-end funds, says Esser. “Pimco’s fixed-income team remains very solid,” she says. The problem is that many of Pimco’s closed-ends are so popular that they trade at premiums to NAV. Look carefully, though, and you can find a few selling at discounts to NAV. Pimco Dynamic Income Fund (PDI, $29, 8.0%), which employs leverage and invests in bonds from all over the world, including non-agency-backed mortgage securities, trades at a 5% discount to NAV. Pimco Dynamic Credit Income Fund (PCI, $20, 9.2%) sells for 10% below its NAV. Also leveraged, the fund has big slugs in non-agency mortgage securities, junk bonds and emerging-markets bonds.
High earners can choose from nearly 200 municipal closed-end funds, many with similar names. Pimco, for example, runs three national tax-free funds with “Municipal Income” in their names. We suggest Pimco Municipal Income II (PML, $12, 6.3%), which trades right around its NAV. About half of the fund’s assets are in muni bonds with maturities of five to 10 years; thanks to leverage, the fund’s average duration is a fairly high 11 years. But for a taxable-equivalent yield of 11.1% for investors in the highest bracket, the fund may be worth the risk. Nuveen is also known for its muni funds. One of its tamer offerings is Nuveen Municipal Income (NMI, $12, 4.3%). The fund employs just a small amount of leverage and thus has an average duration of just 7.6 years. It trades at a 4% premium to NAV. The taxable-equivalent yield is 7.6% for the highest-bracket taxpayer.
Most REITs invest in office buildings, shopping malls and other kinds of commercial properties. However, a relatively small but extremely high-yielding segment of the REIT world specializes in lending money to owners of property or buying mortgages or mortgage-backed securities. Mortgage REITs typically borrow money at short-term interest rates and lend it at long-term rates.
What could go wrong: The big risk, as with any kind of income-oriented investment, is rising interest rates. Mortgage REITs accentuate the risk of rising rates because they use leverage—that is, borrowed money—to amplify their returns. If rates start to rise rapidly, or if there is even a hint that rates will rise, mortgage REITs can get slammed, as they did in the spring and summer of 2013, after the Fed suggested it might soon begin tapering its bond-buying program (which has since ended).
Next slide: Our picks for mortgage REITs.
Look for REITs that either lend at variable interest rates or are good at hedging their interest-rate risk. Tim Plaehn, analyst for income investing at Investors Alley, a research service, likes Blackstone Mortgage Trust (BXMT, $28, 7.3%) and Starwood Property Trust (STWD, $24, 7.9%), both of which make commercial loans at variable interest rates. Among mortgage REITs that are hedging against the threat of rising rates, analyst Merrill Ross, of Wunderlich Securities, favors American Capital Agency Corp. (AGNC, $21, 12.4%) and AG Mortgage Investment Trust (MITT, $19, 12.7%). Ross thinks that their share prices could climb once investors realize that worries about rising interest rates are overblown. Or take the worries out of picking individual mortgage REITs by investing in one of the two ETFs that buy a diversified package of them. Market Vectors Mortgage REIT Income ETF (MORT, 10.5%) gets a slight edge over iShares Mortgage Real Estate Capped (REM, 10.1%) because of its slightly higher yield and slightly lower expenses.
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