Earning 5% on your money may sound pretty lame, but hey, in this interest-rate environment, when bank CDs pay a couple of percentage points, plenty of folks would jump at it.
Reaching for higher yields does mean taking on some more risk. The big one is that higher rates will depress the value of your investment. But if you're happy with the return and you plan to hold on until maturity, say with a municipal bond, then market fluctuations shouldn't discourage you from making the deal.
Still, you have to be picky about choosing these income-oriented investments. We found the best opportunities in municipal bonds, closed-end bond funds, international bonds, and in a lesser-known corner of the market, master limited partnerships and income trusts.
The sweet spot in munis is in the high-yield sector. An improving economy lifts credit ratings in general, and that includes lower-quality bonds, says Mary J. Miller (TROW), fixed-income director at T. Rowe Price Associates. Bonds rated B and BB yield 6% and 5.1%.
But you don't need to go that far down the credit scale to make some money. The current 4.2% yield on a 10-year, BBB-rated muni bond is the equivalent of a 6.5% taxable yield, assuming a 35% federal and state tax rate. If you want nothing but the top tier, the tax-equivalent yields are not bad. The 3.5% you can earn on a 10-year, AAA-rated bond is the equivalent of a 5.4% taxable yield, assuming a 35% bracket.
Sure, a long-term muni is risky in a rising interest-rate environment. But munis are less volatile in price than Treasuries because the market is dominated by individuals who buy and hold rather than institutional investors who trade them often. If you don't need to dump the bond in a hurry, the price volatility should not be a problem.
CLOSED-END BOND FUNDS
You can get yields of more than 6% in closed-end bond funds. Unlike mutual funds, closed-ends have a fixed number of shares that trade on a stock exchange. Depending on demand, closed-ends trade at a price higher or lower than their net asset value (NAV), what the fund's bonds are worth.
As a rule, you only want to buy funds when they sell at a discount to NAV. Discounts for the Van Kampen Income Trust and Oppenheimer Multi-Sector Income Trust are both 12%, resulting in yields of 5.7% and 5.3% respectively. "Those discounts get very wide at the end of the year because of investors taking tax losses on some of their investments," says Thomas J. Herzfeld, whose Miami firm specializes in closed-end funds.
These discounts help boost the returns. Suppose a fund has bonds that pay 5.5%. The fund has an NAV of $10 a share, and it happens to be trading at $10. Then the yield will be 5.5%. But if the fund's shares drop to a 10% discount, or $9, the yield jumps to 6.1%.
Not any fund with a discount will do. The majority of closed-end bond funds are leveraged, which means they borrow money to buy even more bonds. That's not a good strategy when rates are moving up, since the value of the bonds is likely to fall. Unleveraged funds can get hit by rising rates, but not as badly as those that have borrowed to the hilt.
You can look abroad to enhance your portfolio income. In many countries, yields are high enough on their own to beat what's available here. Polish zloty bonds pay 6.1%, Mexican peso bonds are 10%.
Of course, finding an individual zloty bond is no easy task. That's why many investors turn to international bond funds for diversification and convenience. These funds come in three flavors: Some hedge their currency exposure, which means you just make money from the interest on the bonds, not on the changes in currencies. Other funds never hedge, leaving the returns exposed to the ups and downs of the foreign exchange market. Right now, those are attractive because the dollar is weak. The third sort allows portfolio managers to hedge for when they think it will boost their funds' returns.
That's the strategy at Credit Suisse Global Fixed Income Fund, which has a 12-month yield of 10.6%. Credit Suisse also limits currency fluctuations by requiring that at least 65% of its assets be in U.S. dollar-denominated debt. That's not hard to do, since many foreign issuers sell dollar-denominated bonds.
Emerging-market debt is especially attractive these days because the countries are often rich in commodities for which prices are high. Federated International High Income A and AllianceBernstein Emerging Market Debt A, for example, are finding opportunities in Russia and Brazil. Ten-year Russian U.S.-dollar-denominated debt yields 6.6%, and 10-year Brazilian U.S.-dollar-denominated debt yields 8.1%, vs. 4.2% for comparable U.S. Treasuries. What's more, Russian bonds are hot. Two rating agencies already consider them investment grade, and a third is expected to soon follow suit. That's a hat trick that should create more demand -- and higher prices -- for the bonds.
MASTER LIMITED PARTNERSHIPS/INCOME TRUSTS
Master Limited Partnerships (MLPS) and income (or royalty) trusts can offer investors yields up to 10 percentage points over 10-year U.S. Treasuries. MLPs and income trusts, which are mainly in the energy sector, are required to pay out most or all of their cash flow in distributions. Neither pays income tax, so there's no problem with double taxation of dividends. Investors do typically pay their regular income-tax rate -- not the 15% rate on dividends -- on up to 20% of the cash distributions. Taxes on the remaining 80% or so are usually deferred until the investor sells the partnership or trust units. Then the proceeds are taxed at the 15% capital-gains rate.
The median yield for Wachovia Securities' (WB) MLP Composite, comprised of 30 energy companies, is 6.4%. Yves C. Siegel, of Wachovia, recommends Magellan Midstream Partners LP and MarkWest Energy Partners LP, which yield 6.2% and 6.6% respectively.
The highest yields can be found in Canadian income trusts. For example, Pengrowth Energy Trust has a current yield of 12.2%, and Vermilion Energy Trust, 12.8%. Most of the trusts pay out in Canadian dollars, which can provide an added boost if the greenback continues to decline.
While a rise in interest rates hurts most income investments, these vehicles can offset some of that decline by raising their distributions, says Siegel. That's dependent, of course, on energy prices remaining strong. A huge drop in the price of oil or gas will crimp the MLPs' and trusts' ability to pump cash.
By Toddi Gutner