Low rates have the risk-averse hunting for income
It's not called financial repression for nothing. The Federal Reserve's ultra-low interest-rate policy since the financial crisis may have lent support to a listless economy and made the government's massive debt a lot easier to finance, but it's been more than hard on retirees and conservative savers.
For risk-averse investors relying on income from their portfolios, it's been a yield drought, as certified financial planner Barry Glassman puts it. And it's going to continue.
"Yields are likely to stay lower for longer than people expect," said Glassman, founder and president of Glassman Wealth Services. "It's happening on the backs of retirees and conservative investors."
The real yield on a 10-year Treasury bond was 0.72 percent on Nov. 17, and a 30-year bond yields a little more than 1 percent after inflation. While the Fed has indicated it plans to raise short-term interest rates, the uncertain domestic and global economies and the still-loosening monetary policy of central bankers in other countries suggests that rates could remain very low for a long time still.
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Investors who need more income from their portfolios have no option other than taking on more risk.
"There is no free lunch," said Russ Koesterich, chief investment strategist for BlackRock. "If you want more return, you have to take on more risk."
He suggests that conservative investors figure out a combination of different income-producing strategies to manage the extra risk. It could include investing in preferred stocks, global securities with higher dividends or yields, high-yield bonds, real estate investment trusts or energy-related master limited partnerships that pay a high yield.
"The problem is, everyone has been stretching for yield, so you don't find a lot of bargains. But people can't rely on the same instruments [for income] that they did 10 years ago," Koesterich said. "They have to cast a wider net."
Here are three options that investors can consider if they need to boost the income they're getting from their investment portfolio.
While credit risk might seem like a bad idea with the U.S. economy still weak and the rest of the world looking equally uncertain, high-yield bonds do offer bigger returns than government and investment-grade bonds.
The yield on the BofA Merrill Lynch High Yield Bond index rose from just over 6 percent at the end of May to 7.9 percent as of Nov. 17. If you were holding junk before the volatility picked up this summer, you've taken it on the chin.
However, rates have retreated from over 8 percent in the last several weeks, and the credit risk of high-yield bonds can offer some diversification from the interest-rate risk of a portfolio of Treasury bonds.
The Vanguard High Yield Corporate Bond fund (NASDAQ: VWEHX-O) has underperformed Treasuries in the recent downturn, but it still has a positive return of 0.5 percent in the year-to-date through Oct. 27. It invests in relatively high-quality junk and has a current yield of 5.61 percent. If the stock market gets wild again, junk bonds will also get hit, but if you can wait out turmoil, the higher yield will pay you more income.
"You have to be able to withstand volatility," said Glassman, who noted that junk bonds lost 21 percent in 2008. "They recovered almost all their losses in that year within 18 months."
Ron Carson, a CFP and CEO of Carson Wealth Management Group, thinks conservative investors should not take on credit risk given the dicey economy.
"When you reach too far, bad things happen," Carson said. "If you're not certain about what you're doing, doing nothing can be a good option."
A strategy he favors for risk-averse clients who need more income is covered-call option writing. Investors receive premiums for selling others the option to buy a stock at a specific price.
Carson says that writing call options on a basket of stocks with high-dividend yields can generate a return of between 10 percent and 15 percent. He favors writing the calls at between 5 percent to 7 percent above the market price. If the market surges, investors will miss out on returns above that range, but they get the premium income upfront.
"It's more market risk than many people might be used to taking, but I don't think it's worse than duration or credit risk currently," he said. Investors are still vulnerable to big drops in the stock market, but the premium income and dividends from the portfolio can help cushion the blow. "It's a great buffer for big market declines."
Master limited partnerships are high-risk investments. The Alerian MLP Index, which tracks about 75 percent of the market capitalization of MLPs operating in energy-related businesses such as pipelines or energy storage, was down more than 30 percent this year through Nov. 13, and even more from its peak in the summer of last year.
MLPs have become popular vehicles for investors seeking income. Most of them, however, are highly correlated to the price of oil even if their operating cash flows may not be.
A bet on the price of oil is not exactly conservative investing, but MLPs are cheaper than they've been in years, and the income they can offer investors is substantial. The yield on AMZ index, for example, was 8.36 percent on Nov. 13. If oil is at or near a bottom — admittedly, a big if — this could be a great time to buy into MLPs.
"We like where the yields are," Glassman said. "The challenge is that MLPs are tied to the price of oil and to interest rates, and investors need to know what they're getting into."
— By Andrew Osterland, special to CNBC.com
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