In 2006 the yield on a 10-year U.S. government bond hovered around 5 percent; corporate bonds rated BBB by Standard & Poor's yielded between 6.5 and 7 percent. Conservative investors seeking regular monthly income could simply invest in a combination of bank certificates of deposits (COD) and high-grade corporate and government bonds to earn a steady stream of regular income.
Those days are over. The current yield on a 10-year U.S. government bond stands at less than 2 percent, and BBB- rated corporate debt yields just over 4 percent. There's only one guarantee for investors in many fixed-income products: You will lose money. The interest rates offered by CODs and savings accounts won't keep pace with inflation. Even lower-grade corporate debt doesn't offer much additional yield; the average B-rated corporate bond currently yields less than 7 percent.
The outlook for fixed income is unlikely to change anytime soon. On Jan. 25, 2012, the Federal Reserve's press release on interest rate policy declared that the central bank will likely maintain its current zero interest rate policy until at least the end of 2014. That's a full 18 months longer than the central bank had predicted in prior policy statements.
Yields on government bonds will tick up if the economy continues to recover. But there's a long way to go before bonds offer real income that can keep pace with inflation. And if the economy recovers faster than expected, the Fed's accommodative monetary policy could lead to even higher inflation.
The bad news for bonds is great news for dividend-paying stocks. Starved for income, investors are looking for alternatives to traditional fixed-income products and increasingly gravitating toward high-yielding master limited partnerships, U.S. royalty trusts, utility stocks and real estate investment trusts. The Alerian MLP index and Philadelphia Stock Exchange Utility Index, for example, are up 14 percent and 12 percent, respectively, over the last 12 months.
Moreover, income-paying stocks were among the first to recover from temporary sell-offs in the stock market; in fall 2011, for example, investors regarded the dip as an opportunity to lock in higher yields on their investments.
Enterprise Products Partners LP (EPD) offers at least three times the yield of 10-Year Treasuries. This favorite of mine also offers something fixed income assets never can: dividend growth and price appreciation. Enterprise Products Partners has boosted its distribution in 37 consecutive quarters and grown its payout at an average annualized pace of almost 6 percent over the past five years.
Meanwhile, the current rate environment has enabled corporations to raise capital at ultra-cheap rates for terms of 10 years or longer. The best income-paying stocks are deploying that capital to fund growth projects or accretive acquisitions that allow them to boost their payouts.
The shift of capital away from bonds and other fixed-income staples and into dividend-paying stocks will continue to provide a major tailwind for high-yield stocks over the next few years.
But it's also important to maintain your buying discipline: In their zeal, investors occasionally bid up the prices of income-paying stocks beyond a reasonable valuation. Be sure to avoid overpaying.