Reinvestment Riddle

How you deal with appreciated bonds should depend on what kind of investor you are.

For Jack Peters of Las Vegas, interest rates can't start rising soon enough. Harvey Silver, who's from New York City, is content if rates stay where they are. Both men are retired and in their mid seventies, and both have done well with the income investments they made in the past. But now Peters's certificates of deposit are coming due, and he wonders how he'll reinvest the proceeds. Meanwhile, Silver worries that his paper gains on corporate bonds are about to evaporate. Both men are antsy -- and with good reason.

Peters's CDs, which he bought about ten years ago, pay interest rates of 7.75% to 8%. The yield on comparable CDs today: 3%. A few years ago, Silver bought a pile of medium-maturity, triple-B-rated corporate bonds yielding 5% to 6%. Since then, the bonds have appreciated 10% to 20%. Silver can sell and pocket the profits, or he can keep the bonds and extend this respectable income stream. But if he holds the bonds, he'll sacrifice the capital gains once interest rates start climbing in earnest.

Bond-market indecision. The problems these gentlemen face remind us that it is a challenging time to juggle an income portfolio. One day, the economy looks as if it is recovering, suggesting that rates will rise sooner rather than later. That's alarming if you own bonds because higher rates reduce the value of existing bonds. But the next day, investors get spooked by one thing or another and rush into T-bonds, leading to higher prices and lower yields. That helps current investors in Treasuries, but it's a bummer for those searching for a better deal on CDs, savings bonds and money-market funds.

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Peters and Silver have their own ideas for finding income in a low-yield world. Peters thinks electric-utility stocks would make suitable replacements for his CDs. Not a bad idea, says Harry Rady, of Rady Asset Management, in San Diego. Rady says utility stocks, lousy performers over the past year, are inexpensive. With utilities, he adds, you get a reliable stream of dividends while you wait for the stocks to appreciate. Traditional bellwethers such as Consolidated Edison (symbol ED), Florida Power & Light (FPL) and Southern Co. (SO) yield more than 5% and are known for hiking their dividends regularly. If and when CDs again yield more than utilities, Peters could switch off some of the electricity and return to the bank.

Silver's situation is more complicated. Buckets of single-A- and triple-B-rated corporate bonds that traded at 90 to 100 cents on the dollar a year or two ago now go for $1.10 to $1.20 on the dollar. If you hold on to a bond that's trading at a premium until it matures, you'll get $1 back (that is, $1,000 per bond), forfeiting your paper profit. Silver is thinking about selling now and putting the cash into instruments with respectable yields that won't lose much value if interest rates rise. His ideas include master limited partnerships and energy royalty trusts.

How you deal with appreciated bonds should depend on what kind of investor you are, says Bill Larkin, of Cabot Money Management, in Salem, Mass. If you focus on total return (income plus gains) rather than on income alone, Larkin says, you should sell the bonds, claim the gains and spread the proceeds among stocks, short-term bonds, balanced mutual funds and anything else that's consistent with your investment strategy. Silver's idea of buying energy income securities makes sense if you think the economy will continue to expand rapidly, as it did in the fourth quarter of 2009. Strong growth tends to boost demand for energy and, hence, energy prices.

But if you hold high-yielding investment-grade bonds and you invest primarily for income, Larkin recommends that you keep them and ignore the fluctuating prices. When a good company such as American Express or Wal-Mart owes you 7% or 8% (on your original investment) for years on end, why let go? Bonds with that kind of pedigree are safe enough that they're just about as good as CDs.

Jeffrey R. Kosnett
Senior Editor, Kiplinger's Personal Finance
Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.