Investing: Income Plays for a Low-Yield World

With the latest spike in volatility in the stock market, investors are getting increasingly anxious about where to go for predictable but still attractive returns on investment.With yields on U.S.Treasuries and agency bonds near all-time lows, income investors will have to look elsewhere.

Remarks from the Federal Reserve's policymaking committee on Aug. 10 offered scant hope of meaningful upside in asset prices any time soon. The committee kept the target range for the federal funds rate at zero to 0.25 percent and said that "economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

While that's no surprise to anyone who's been tracking key economic data releases over the past few months, it's not what yield-seeking investors want to hear.

Risk Appetite

Issuance of high-yield corporate bonds hit record levels of at least $12.9 billion last week, after climbing for five straight weeks prior to that, according to data compiled by Bloomberg. But with the Fed's warning that the economic recovery may be slowing and reduced growth outlooks in the U.K. and China, some strategists believe investors' appetite for higher-risk assets may begin to wane.

Not David Garrett, a financial adviser in Logan, Utah. The financial crisis and the prospect of a long road to recovery, during which interest rates will likely remain depressed, have put investors on the prowl for higher-yielding assets, he says. He has developed an investment strategy using active management to buy and hold high-yield bonds when they're rising and sell them when prices drop. "We feel the market is coming our way," he says, as the income component of stocks starts to eclipse any gains from share price appreciation, which he expects to be minimal over the next 10 years.

Garrett sees a "sweet spot" in corporate high-yield bonds, which he prefers to hold in a diversified open or closed-end fund as opposed to single issues. He continues to hold two exchange-traded funds—the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK). The iShares ETF's current yield is just under 9.0 percent, while the SPDR ETF is yielding 10.8 percent. By comparison, the Bank of America Merrill Lynch High Yield Master II Index yields 8.6 percent.

Dividend Appeal

If you're not shaken by the spike in volatility in the stock market over the past three months—and believe the argument that performance over the next 10 years has to be better than over the past decade—you might want to stick with dividend-paying stocks since the income stream they provide is much less volatile than any potential moves in share prices, says Cliff Remily, co-manager of the Thornburg Investment Income Builder Fund (TIBAX). While investors have been shifting money from stocks into bonds amid ongoing signs of economic weakness, they aren't pulling money as fast from dividend-paying stocks, says Remily.

His fund, now weighted 70 percent to stocks and 30 percent to bonds, has outperformed its benchmark, the Standard & Poor's 500-stock index, by 4.0 percent year-to-date as of Aug. 13. "With a dividend yield of 6.0 percent, most of our performance has been due to income," he says. "We've protected on the downside, which is what these strategies should do."

Remily agrees that income will become much more important to investors than share price appreciation during this time, partly due to stability. There's "scarcity value" in companies able to deliver growing income and investors will eventually recognize that value, while companies that don't provide a growing income stream will become less desirable, he says. Unlike fixed-income assets, stocks with a growing income stream will outperform when there's inflation as well as deflation, he adds.

Munis Passed Over

Municipal bonds, historically favored for their tax exemptions, are no longer much of a draw. The scarcity of supply relative to demand has significantly driven down yields and yield spreads over comparable duration, says James Sarni, senior managing partner at Payden & Rygel in Los Angeles. You'd have to go out to at least a seven-year maturity to be able to break even on munis compared with the yields on taxable bonds, he says.

Sarni prefers below-investment-grade corporate issues and recommends double-B-rated bonds maturing in three to five years, which represent the best tradeoff between maximizing yield and maintaining the value of your portfolio if and when interest rates rise, making your lower-yielding bonds less desirable. A four-year bond should be able to avoid a sharp price decline since, by the time interest rates are likely to start to rise a year from now, it would have only three years left to maturity, he says.

He likes Ford Motor's (F) single-B-rated bond that matures in 2013 and has a yield around 5.8 percent, and also favors Wynn Resorts' (WYNN) double-B-rated bond that is yielding 6 percent and matures in 2014.

Trust Preferreds

Trust preferred securities, which fall somewhere between corporate debt and preferred stock, are a relatively safe place to find yield during times of economic uncertainty, says Bill Larkin, portfolio manager for fixed income at Cabot Asset Management in Salem, Mass. They pay a fixed amount in interest quarterly, can be redeemed before maturity at whatever the market value is at the time, and mature at face value. Rather than trying to pick individual securities, investors would do better to buy the iShares S&P U.S. Preferred Stock Index (PFF), an ETF that represents the broad spectrum of trust preferreds, with a current yield of 6.92 percent.

When it comes to standard corporate bonds, Larkin believes the "sweet spot" are those rated triple-B-minus and double-B, with a three-year bond yielding around 5.5 percent, three to four times what a government agency bond yields. That "rate of return is somewhat in line with the risk you're taking," he says.

There are many companies with triple-B ratings that have solid business models, good free cash flow, and that will be around for decades, he says. Their yields tend to be higher because there are fewer buyers in that marketplace. Many mutual-fund managers are restricted from buying speculative-grade bonds, while high-yield bond managers view triple-B-rated bonds as too expensive compared with single-B-rated and even triple-C-rated bonds that offer higher yields, he says. Larkin focuses on bonds maturing in three to eight years, the steepest part of the yield curve.

"If we do get stagnant economic growth that the bond market is predicting, you're rolling down the curve" as the bond ages and the Fed stays on hold with interest rates, he says. "The bond's yield sticks out and it becomes a very attractive [asset]." You don't pay any capital gains if you hold these bonds until maturity and "you're getting a lot more stability than if you were invested in stocks, where people are questioning the return scenario."

Expert Picks

When he's confused about the direction of the market, Larkin says he lets expert bond managers at Pimco or Eaton Vance choose his investments. One example is the Pimco Income Fund (PONDX), an unrestricted, go-anywhere fund that buys bonds due to mature in three to 10 years, regardless of their credit rating. "Unrestricted is important today because of the crowded areas of the market," he says. "You want to make sure that management can avoid the pricey parts" of the market.

These managers are adept at identifying mispriced issues whose spreads have widened significantly due to adverse events in certain industries. They were able to exploit opportunities when the mortgage-backed securities market collapsed two years ago and probably found some good buys in Anadarko Petroleum's (APC) debt after the explosion of BP's (BP) Macondo well and the resulting oil spill in the Gulf of Mexico, he says.

Although higher-yielding assets clearly have elevated risk, the multiples are worth it, "especially if you believe the economic recovery is in place, which I do," says Larkin. Still, given the possibility of high default rates on debt, diversification through vehicles such as ETFs might help investors avoid some sleepless nights until the recovery is on firmer footing.

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