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All Contents © 2017The Kiplinger Washington Editors
By Daren Fonda, Senior Associate Editor
| May 2016
Illustration by John Tomac
Heading into 2016, it looked as if income seekers might finally catch a break. With the economy revving up, the Federal Reserve finally lifted its benchmark short-term interest rate last December. In theory, that should have nudged up rates on bank deposits and rippled through the bond world, pushing yields up to more-attractive levels.
Yet the markets have largely shrugged at that logic. True, you can now squeeze out a bit more income from money market funds and other types of short-term savings accounts. But long-term bond yields, which the Fed doesn’t directly control, have slumped as investors bet that the economy isn’t strong enough yet to handle higher rates. Buy a 10-year Treasury note and you’ll pocket a 1.8% yield, down from 2.2% at the start of 2016. At that pace, your income won’t even keep up with “core” inflation, which excludes food and energy costs and, Kiplinger expects, will rise 2.4% this year.
But traditional savings accounts and bonds aren’t the only way to go. Opportunities abound in other areas, ranging from high-yield checking accounts to real estate securities and foreign bonds. Investing in these categories involves varying degrees of risk. But blending income from different sources can smooth out the bumps in any given part of the market. Check out these 9 ways to get paid.
Stock prices and other data are as of March 31.
Even with the Fed swinging into action, savings rates remain minuscule, averaging just 0.16%. Yet some banks offer you much more—as much as 4%—if you follow certain rules.
Online-only banks usually pay more than branch-based institutions. For example, Incredible Bank, which exists only in the virtual world, pays 1.2% on savings deposits from $2,500 to $250,000. But there’s a catch: Depositors who exceed six withdrawals or other types of transactions per month start to rack up fees.
For a 4.6% yield on up to $20,000, consider opening a rewards checking account at Consumers Credit Union, based in Gurnee, Ill. Rules include spending at least $1,000 a month on a CCU credit card, conducting 12 or more debit card transactions each month, and doing some banking online. Anyone can join the credit union for a one-time fee of $5.
Rates on most CDs can’t beat high-yield checking accounts. But CDs can make sense if you “ladder them up,” says Greg McBride, chief financial analyst at Bankrate.com. Take, say, $10,000 and split it into five $2,000 chunks, buying CDs maturing in one, two, three, four and five years. As each certificate matures, buy another five-year CD with the proceeds. If interest rates increase, you can take advantage of higher yields. “The landscape for savers won’t improve dramatically in the near term,” says McBride, but rates could be higher in a year or two. One good option now: a five-year CD from First Internet Bank of Indiana, yielding 2.1%. To find more deals, go to www.depositaccounts.com or www.bankrate.com.
On the surface, bonds issued by state and local governments don’t pack much of a yield punch. But Uncle Sam generally doesn’t tax muni interest, which may be exempt from state taxes, too. Those breaks add up, especially for investors in the higher tax brackets. A 2% yield from a muni bond translates to a taxable yield of 3.3% for taxpayers in the top, 39.6% bracket. Add in a 3.8% Medicare levy on high-income earners, and the taxable-equivalent yield of 2% tax-free climbs to 3.5%.
Even after a strong two-year run—with high-quality tax-free bonds returning an average of 9.1% in 2014 and 3.3% in 2015—the market still looks “a little cheap,” says Hugh McGuirk, head of municipal investments at T. Rowe Price. After taxes, muni yields exceed those of Treasury bonds with similar maturities. And despite headlines about states and other jurisdictions with shaky finances—notably Illinois and Puerto Rico—almost all muni issuers honor their obligations. Individual muni bonds default at a rate of less than 0.2% a year, which is well below the default rate for high-quality corporate bonds.
Risks to your money. Credit-rating cuts could send bond prices spiraling. States with a “negative” ratings outlook now include Alaska, Louisiana, New Jersey and Pennsylvania, according to Moody’s. Rising interest rates would lower the value of existing bonds and depress share prices of muni funds (though higher interest payments would offset the losses over time). Inflation may eat away at the value of your principal and interest payments.
Hire a pro. Residents of high-tax states should buy funds that hold bonds issued by their state or local government. Two top mutual fund choices for California and New York residents are Vanguard California Long-Term Tax-Exempt (symbol VCITX, yield 1.9%) and Vanguard New York Long-Term Tax Exempt (VNYTX, 1.8%). If state taxes aren’t a concern, go for iShares National Muni Bond ETF (MUB, $111, 1.5%), an exchange-traded fund that holds hundreds of munis issued by state and local governments across the country. T. Rowe Price Tax-Free High Yield (PRFHX, 2.8%) pays substantially more, but the mutual fund’s bonds have lower credit ratings and are more susceptible to default or a slump in price if their issuers run into financial troubles.
Do it yourself. Individual bonds can be a good bet if you hold them to maturity. But you should take this route only if you can plow in at least $50,000, spread over several bonds, in order to stay well diversified. A San Diego Redevelopment Agency bond, rated double-A, recently yielded 2.5% to maturity in 2027. And a Chicago O’Hare International Airport revenue bond, rated single-A, yielded 3.4% to maturity in 2031. Neither bond can be called, or redeemed, until 2025, and their issuers should generate enough steady revenue to meet their interest payments until the debt comes due, says Dusty Self, comanager of the RidgeWorth Seix Short-Term Municipal Bond Fund.
SEE ALSO: Income Investing: Why I Stand by Muni Bonds
Corporate bonds and government-agency and mortgage-backed securities can all deliver more income than Treasuries. The additional yield embedded in these investment-grade bonds should also help them retain more of their value if interest rates do eventually climb.
Risks to your money. Higher rates would depress prices of existing bonds. Other pitfalls include credit-rating downgrades or signs that corporate balance sheets are coming under pressure.
Hire a pro. Fidelity Corporate Bond (FCBFX, 3.8%) focuses on high-quality, intermediate-term bonds to pump out a robust stream of income. Pimco Income Fund (PONDX, 3.4%), a member of the Kiplinger 25, includes a broad mix of bonds, including corporate IOUs, mortgage-backed securities and some junk issues. Moreover, its bonds mature in an average of six years, limiting interest-rate risk. Vanguard Intermediate-Term Investment-Grade (VFICX, 2.6%) invests mainly in high-caliber bonds at the shorter end of the maturity spectrum—qualities that should help the fund hold up if the bond market takes a tumble. For a pure play on corporate bonds, consider exchange-traded iShares Core U.S. Credit Bond ETF (CRED, $110, 3.2%).
Do it yourself. Individual IOUs can be a good way to pocket reliable income that won’t fluctuate over the lifetime of the bonds (unlike a fund, whose yield can bob around). Bonds issued by chip maker Qualcomm look attractive, says Scott Kimball, comanager of the BMO TCH Core Plus Bond Fund. The tech firm’s bonds maturing in 2025 yield 2.9% and earn an A rating for quality. Also compelling are bonds from drugmaker Abbvie, rated single-A and yielding 4.2% to their 2035 maturity. In the financial sector, Kimball likes bonds issued by financial giant Citigroup, rated triple-B and yielding 4.3% until they come due in 2026. None of the bonds is callable before the maturity date, he adds, making all of them solid choices for steady income.
Owning everything from office buildings to self-storage facilities, REITs rake in rents and must pay at least 90% of their taxable income to shareholders. As long as they can keep raising rents and dividend payments, the stocks should fare well. Indeed, REITs’ underlying properties should post a 4.5% average gain in operating income this year, fueling dividend growth in the “high single-digit” range, says investment firm Lazard.
Risks to your money. Rising interest rates could hurt REITs, which typically take on a lot of debt to buy properties. Steeper rates would increase their financing costs and could depress real estate values. Some types of REITs are pricey, and some may not be able to hike their dividends.
Hire a pro. Yielding 2.4%, T. Rowe Price Real Estate (TRREX) emphasizes big, high-quality REITs. Although its yield is relatively low, it earns high marks for consistency and avoiding big losses in down markets, says Morningstar. Vanguard REIT ETF (VNQ, $84), which tracks an index of REIT stocks, costs just 0.12% in annual fees and yields 4.1%.
Do it yourself. In the residential space, AvalonBay Communities (AVB, $190, 2.8%) looks appealing. Managing more than 83,000 apartment units in 11 states and Washington, D.C., the firm reported a 5.4% year-over-year increase in rental revenues in the fourth quarter of 2015. It’s also expanding steadily, with acquisitions and new developments, and is “firing on all cylinders,” says Credit Suisse, which expects the stock to hit $200 in the next 12 months.
Crown Castle International (CCI, $87, 4.0%), a REIT that owns cell-phone towers, is benefiting as wireless networks expand. Tenants are major telecom firms that typically sign long-term leases with Crown. With its tower network growing steadily, the REIT aims to hike its dividend by 6% to 7% annually over the next few years.
Also attractive is EPR Properties (EPR, $67, 5.8%), a REIT that focuses on recreational venues, such as movie theaters and golf courses, along with charter schools and day-care centers. With revenues rising, the REIT should generate annual returns, including dividends, in the “mid teens,” says Matthew Berler, comanager of the Osterweis Fund.
SEE ALSO: 11 Great Dividend Stocks for Income Investors
Shooting for extra income? It can pay to venture offshore. Yields on bonds issued by foreign governments and companies often beat comparable U.S. rates. Moreover, central banks in Europe and Japan recently cut interest rates, while the Federal Reserve has embarked, gingerly, on the opposite path. Such divergences can make foreign bonds a better bet than U.S. bonds, which stand to lose value if rates continue to increase at home.
Risks to your money. Swings in foreign currencies may be tough to overcome. If the dollar were to resume its ascent, bonds based in other currencies would likely slump. Moreover, even dollar-based foreign debt could slide if local economic conditions decline or interest rates climb. Companies and governments may also have a tougher time repaying their debts if the dollar gains value (making their local currencies worth less and hiking their interest costs).
Hire a pro. T. Rowe Price Global Multi-Sector Bond (PRSNX, 3.7%) holds half of its assets in foreign bonds, ranging from Canadian government debt to securities issued by companies such as Deutsche Bank and Schlumberger. At last word, 47% of the fund’s assets carried junk ratings or were unrated. That bumps up its yield but could magnify losses. Kiplinger 25 member Fidelity New Markets Income (FNMIX, 6.4%) keeps nearly all its assets in dollar-based securities, with 60% at last report in government bonds and 30% in corporate debt (the rest is in cash and stock ETFs). Also compelling is iShares J.P. Morgan USD Emerging Bond ETF (EMB, $110, 4.8%), which mainly holds government bonds issued in dollars. Emerging markets are highly volatile, though, and this fund, a member of the Kiplinger ETF 20, could hit some lengthy rough patches.
SEE ALSO: Negative Interest Rates? No Way, USA
Preferred stocks combine elements of stocks and bonds in one investment. Typically issued at $25 a share, they pay a fixed rate of interest like bonds do. But preferreds trade like stocks and can bounce above or below the issue price. Preferreds tend to pay more than comparable bonds because they’re riskier. An issuer may be able to delay or cut payouts, and if the preferred is “non-cumulative,” the issuer isn’t on the hook to pay missed dividends. Issuers do owe all payments if a preferred is “cumulative,” but yields for these securities tend to be lower.
Risks to your money. Similar to long-term bonds, preferred stocks tend to be sensitive to interest rate moves. Companies may be able to redeem, or “call,” their preferred shares at any time, potentially saddling investors with losses. Preferred stocks, which tumbled during the financial crisis, could dive if investors lose faith in banks and other issuers.
Hire a pro. The exchange-traded iShares U.S. Preferred Stock ETF (PFF, $39, 5.8%), a member of the Kiplinger ETF 20, offers access to hundreds of preferred securities issued by firms such as Allergan, HSBC and Wells Fargo. Banks and other financial firms account for 60% of its assets, though, concentrating most of the fund into one sector. Market Vectors Preferred Securities ex-Financials ETF (PFXF, $20, 6.0%) tracks an index of nonfinancial preferreds.
Do it yourself. With individual securities, stick to financially solid companies and buy shares below or only slightly above their $25 issuance price, says Michael Greco, cofounder of GCI Financial, an investment firm in Mendham, N.J. One preferred he likes: JPMorgan Chase 6.15% Non-Cumulative Preferred Series BB (JPM-PH, $26, 5.9%). Shares can’t be redeemed by JPMorgan until 2020, and dividends are considered to be “qualified,” meaning the maximum federal tax rate on the payments is 15% or 20%. Greco also favors Chesapeake Lodging Trust 7.75% Preferred (CHSP-PA, $26, 7.4%). A real estate investment trust, Chesapeake owns hotel properties such as the Hyatt Regency Boston and should easily cover its dividend payments, says Greco, though they don’t qualify for preferential tax treatment.
SEE ALSO: Why Dividend-Paying Consumer Stocks Are Worth a Look in This Market
Similar to more-popular ETFs, closed-end funds hold baskets of securities, such as stocks or bonds. But, unlike with ETFs, the share prices of closed-end funds tend to diverge much more from the underlying value of their assets. As a result, closed-ends often trade well above or below their net asset value (NAV) per share. When a fund trades below its NAV, the discount is like a margin of safety, similar to buying a dollar’s worth of assets for 90 cents. Ideally, you want to buy a closed-end fund when it sells at a discount to NAV and wait for that discount to narrow, or even turn into a premium, enhancing the returns you get from the performance of a fund’s assets.
Risks to your money. Many closed-ends borrow money to buy securities. That additional debt, which can exceed 30% of a fund’s assets, pumps up the yield but can amplify losses. If interest rates increase, it can be a double-whammy: Many closed-end funds hold bonds and other interest-sensitive securities that would lose value, and the cost of their own debt would increase. One other caveat: Some funds aim to hit distribution targets each month, and if they can’t meet their goal with income or investment gains, they pay out capital. Essentially, that means they may give investors some of their money back as distributions, a practice that can erode the share price over time.
Hire a pro. If you’d rather not pick individual funds, a couple of ETFs can do it for you. The PowerShares CEF Income Composite Portfolio (PCEF, $22, 8.3%) holds a basket of 145 income-oriented funds that invest mainly in corporate and high-yield bonds. It recently traded at an 8.9% discount to NAV. Encompassing a broader mix of funds, the YieldShares High Income ETF (YYY, $18, 10.6%) keeps about two-thirds of its assets in bond funds and the rest in stock funds. The ETF trades at a slight premium to its NAV.
Do it yourself. Nuveen Muni Market Opportunity (NMO, $14, 5.4%) holds more than 90% of its assets in investment-grade tax-free bonds. It trades at a 9% discount to NAV—an attractive price for a high-quality mix of bonds, says John Cole Scott, chief investment officer of Closed-End Fund Advisors, an investment firm in Richmond. For top earners, the 5.4% tax-free yield is equivalent to 9.5% from a taxable security.
If you can handle more risk, go for Advent Claymore Convertible Securities & Income (AVK, $13, 8.5%). Holding convertible securities and other types of debt, the fund trades at a deep, 15% discount. Also compelling, says Scott, is Nuveen Diversified Real Asset Income (DRA, $16, 10.0%), which holds real estate investment trusts, preferred securities and bonds. The fund trades at a 15% discount to NAV.
Issued by firms with below-average credit ratings, these bonds pay much more than investment-grade IOUs. The average “junk” bond now yields 8.4%, according to Merrill Lynch, up from about 5% in mid 2014. Today’s plump yields should help the bonds retain more value should interest rates rise.
Risks to your money. Defaults are rising, led by the energy, metals and mining industries. Ratings agency Fitch predicts that high-yield bonds will default at a rate of 6% in 2016, up from 3.5% in 2015. Although that’s well below peak rates of about 10% in a typical market cycle, making money gets harder when defaults are escalating, says Marty Fridson, a veteran high-yield analyst. Moreover, outside of commodity-related bonds, junk looks to be “fairly or richly valued,” he says.
Hire a pro. Treading cautiously makes sense in this environment. Osterweis Strategic Income (OSTIX, 7.6%) has held up relatively well in past downturns and should continue to limit losses if the high-yield market stumbles. Lead manager Carl Kaufman looks for businesses he believes are improving and are candidates for a ratings upgrade. Such discipline keeps him far away from the energy patch.
Vanguard High Yield Corporate (VWEHX, 5.6%), a member of the Kiplinger 25, sticks with debt in rating tiers just below investment grade. Its conservative stance should make it a better bet in a junk slump. For more income, go for iShares 0-5 Year High Yield Corporate Bond ETF (SHYG, $45, 6.6%). It owns bonds maturing in less than five years, limiting its interest-rate risk. Energy-related bonds make up nearly 9% of its assets. That could hurt results if the rally in oil prices falters.
SEE ALSO: How to Avoid Funds That Might Freeze Your Assets
The crash in energy prices devastated MLPs, most of which run pipelines to transport oil and gas. From August 2014 through early February 2016, the Alerian MLP index lost almost 60% of its value, including reinvested dividends, before beginning a recovery. The good news: The slump in share prices pushed up MLP yields to a lush 8.7%, on average. That makes them more attractive than most other income investments. But settle in for a bumpy ride with these stocks.
Risks to your money. Many MLPs have shaky balance sheets and may need to raise capital to fund their expansion plans. If the recent rebound in oil prices fails to take hold, some domestic energy producers could go belly-up or try to renegotiate pipeline contracts, reducing revenues for MLPs. Firms may cut distributions (which are like dividends) or lower the growth of future payouts. Investors who own individual MLPs receive K-1 tax forms, which can be a headache at tax time.
Hire a pro. Alerian MLP ETF (AMLP, $11, 11.0%) bundles major pipeline firms into one package. Investors receive a standard 1099 tax form rather than a K-1, and distributions are treated as tax-deferred return of capital. But the ETF is required to pay corporate taxes on MLP distributions before they’re paid out to investors; that reduces its income and total returns, making it an inefficient way to invest. The iPath S&P MLP ETN (IMLP, $17, 8.0%), an exchange-traded note, is a bit more tax-efficient because it’s set up to avoid owing corporate taxes. But the ETN mainly distributes ordinary income, which is taxed at an investor’s ordinary-income rate. In addition, keep in mind that an ETN is an unsecured debt security (in this case, issued by Barclays) that could theoretically default on its obligation to pay.
Do it yourself. Enterprise Products Partners (EPD, $25, 6.3%) owns a vast network of pipelines, storage depots and other income-producing assets. Prudently managed, the firm recently hiked its quarterly payout by 5.4%, to 39 cents per unit (equivalent to a share). Spectra Energy Partners (SEP, $48, 5.3%), which runs natural gas pipelines, also looks solid. It raised its quarterly distributions by a total of 8.3% in 2015 and is developing more than $8 billion worth of projects that should help it continue to boost its payout. (For more on Spectra, see 8 Stocks Buffett Is Buying … or Should Be.)
One higher-yielding MLP that should fare well is Western Gas Partners (WES, $43, 7.4%). A natural gas pipeline firm controlled by energy producer Anadarko Petroleum, Western has been steadily hiking its distributions and should continue to boost its payout as Anadarko funnels more pipeline and gas-processing assets to the partnership.
SEE ALSO: Why You Should Buy and Hold Exxon Stock as Oil Rebounds
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