Income Strategies for a Low Yield Environment

by: AAII

The Federal Reserve continues to be the enemy of savers. The minutes of the September Federal Open Market Committee (FOMC) meeting, released earlier this week, signaled the possibility of new actions to bring long-term interest rates down further. Specifically, several committee members stated that if the pace of the economic recovery does not strengthen or if inflation does not intensify, "they would consider it appropriate to take action soon."

What could this action be? Most likely, it would involve the Fed purchasing more Treasury securities. Since bond yields are inversely related to bond prices, more demand for Treasuries should effectively drive down yields. The FOMC also considered providing some type of target rate for either inflation or nominal GDP. (A nominal rate includes the impact of inflation. Conversely, a real rate is the nominal rate less the rate of inflation.)

Any such action would be referred to as a second round of quantitative easing, or as folks in the financial industry prefer to say, "QE2." It is not definitively known if the Fed will act, though many economists think an announcement could be made on November 3, at the end of a two-day FOMC meeting. As stated below, in The Week Ahead section, eight Fed officials will make public speeches next week, so we could get some additional hints.

None of this is particularly helpful if you rely on your portfolio for income. Rather than fretting, however, focus on navigating your portfolio through the current interest rate environment. Barring an unexpected improvement in the economic data, the Fed seems likely to keep interest rates low for an extended period of time. That said, interest rates will eventually rise as inflation intensifies. (Ibbotson calculates that U.S. inflation has averaged 3% per year since 1926.)

Since the future is never what we expect it to be, the best portfolio moves are those based on what we know about individual asset classes. Here are some things to consider.

Bonds - Bonds play three important roles in a portfolio. First, they provide a fixed stream of income. Second, bonds offer return of capital when held until maturity. (Corporate bonds are not completely without risk, so be sure to monitor the fiscal health of the issuer.) Finally, bonds have historically had low correlations with stocks. (When stock prices zig, bond prices often zag.) Thus, even in the current low-yield environment, bonds should not be ignored.

The obvious problem with bonds right now is that you can be stuck with securities that pay a low rate of interest. If inflation rises, the low yield could cause you to lose money on an inflation-adjusted basis. There is also the problem of reinvestment risk, meaning current bonds are paying a lower rate of interest than maturing bonds are. This happens when a higher-yielding bond matures in a lower interest rate environment. You are effectively being penalized for maintaining your portfolio allocation to bonds.

There are strategies that can be used without exposing yourself to significantly more credit risk (the risk of a bond issuer defaulting). The first is to ladder your bonds. This is financial-speak for buying bonds of varying maturities. Since you don't know when interest rates will actually rise, you take the timing element out of your investing decisions. (This is akin to dollar cost averaging with stocks.) The second is to invest in overseas bonds. An international bond exchange-traded fund (ETF) or a mutual fund can help facilitate this. Though there is currency risk - the chance that the greenback will appreciate against a foreign currency, thereby decreasing the dollar value of international bonds and their interest payments - you'll lessen your direct exposure to U.S. interest rates. Finally, you could buy Treasury Inflation-Protected Securities (TIPS) whose principal and interest payments adjust with inflation.

REITs - Most real estate investment trusts manage property, such as office buildings and apartments. Some, however, do own mortgages and mortgage-backed securities. REITs trade with higher yields since they must distribute at least 90% of their income to shareholders annually. The negatives are higher correlations with stocks and a dependency on the health of the real estate market. Taxes can be more complicated too, since distributions are allocated to ordinary income, capital gains and return of capital.

MLPs - Master limited partnerships are most often found in the energy sector, and many operate pipelines. MLPs have higher yields because pretax income is passed along to the unitholders. Though they can provide a higher stream of income than stocks and many bonds, taxes are more complicated. Furthermore, MLPs are problematic when held in an IRA if annual distributions top $1,000, and debtholders can force unitholders to pay back distributions. (MLPs are traded as units instead of shares and pay distributions instead of dividends.)

Preferred Stock - This is a hybrid security that also provides higher yields. The advantages of preferred stock are that preferred shareholders are entitled to receive dividends before common shareholders. Plus, dividends are cumulative: If a dividend payment is missed, preferred shareholders must be paid all past due dividend payments before the common stock dividend can be reinstated. The downsides are that voting rights are limited, bondholders have a priority claim to all assets in the event of bankruptcy, and prices are sensitive to interest rate movements.

Keep in mind that while REITs, MLPs and preferred stock can supplement portfolio income, they do not provide the portfolio allocation benefits that bonds do. In addition, REITs, MLPs and preferred stocks must be sold to get your investment dollars back, whereas bonds pay a set amount of money (e.g., $1,000 per bond) at maturity, even if market conditions are worse than when you purchased the security.

Thus your goal should be to maintain a proper allocation to bonds and use other asset classes to increase your portfolio income, instead of simply avoiding bonds because of the ongoing uncertainty about future interest rates.