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Options for investors to increase yields in a low-return market
A laddered bond portfolio, callable bonds and the high-yield bond market are good income choices when interest rates are low.
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While interest rates increased slightly in 2003, yields for income-producing products remained at all-time lows. Those invested in CDs and money market accounts could not earn much return net after taxes. CDs paid an average of 1% for a 6-month investment with only a 3% return on 5-year paper. Treasury bond buyers were forced to go out as far as 30-year maturities to earn more than 5% annually. And interest on these types of securities is taxed at ordinary income rates. What is an income investor to do?
I am a growth stock investor, and I build growth stock portfolios for my clients. However, I understand the concern of my clients and other investors who wish to hold a portion of their assets in income-producing securities. As with stock investments, increasing returns necessitates taking more risk, even in the fixed-income world.
Credit risk, laddering
Accepting some credit risk will increase returns. Investing in adjustable-rate mortgages and floating-rate bank loans significantly increases return over CDs and cash equivalents. There is some principal risk to mortgages in that the mortgage holder might default on payment. However, investing in an adjustable-rate mortgage means that as rates of return increase, the mortgage holder can increase the rate of return for that mortgage. This protects the investor from exposure to rising interest rates. In the investment world, as interest rates rise, current fixed-income products locked into the lower current rates lose value.
Laddering a bond portfolio in today’s low-return market is another possibility. With a laddered bond portfolio, maturities are staggered so some bonds mature regularly over a period of years. Redemption proceeds are then reinvested further out the ladder time frame. This type of portfolio allows the investor to hedge against rising interest rates by frequent reinvestment of maturing bonds. In today’s market with such low rates, the reinvestment risk is minimal. Chances are that at some point new bonds purchased at future dates will be at higher rates of return, not lower rates of return. It is when interest rates are high and investors are likely to invest future dollars at lower rates of return that laddering becomes a bad idea.
Other options
Callable bonds are also a better option during this period of low rates of return. One of the risks of callable bonds is that the bond will be called (paid off), leaving the investor to find a new home for his cash, often at a lower rate of interest. In today’s market, it seems more likely that interest rates will rise at some point in the future rather than fall. As rates rise, it is less likely that the bond will be called to refinance at a new rate.
Dividend-paying stocks have become more popular. Under the 2003 tax law, most investors will pay approximately 15% tax on dividends. Preferred stocks and dividend-paying stocks could be a step toward the equity side that income investors might feel comfortable taking.
Real Estate Investment Trusts (REITs) are an equity asset class popular for their yield. The rise in real estate prices has helped these assets produce positive returns. Average yields in January were approximately 6%. Office property REITs average 6.4% returns, as do mortgage REITs. Residential apartment and health care REITs currently average 6.3% yields.
Junk bonds
With investors concerned about returns, the high-yield bond market has become popular once again. Nearly $25 billion was invested in junk bonds during 2003, and according to AMG Data Services, the average junk bond yielded nearly 8% in 2003 compared with the average corporate bond return of less than 5%.
Investing in the high-yield bond arena means accepting more risk. However, as the economy strengthens, the default rate for junk bonds will probably decrease as well. There is also inequality among high-yield bond funds, even among funds holding the same average credit quality. For example, one fund might hold nearly all BB credit-rated bonds while its competitor might hold lower-quality bonds with just enough high-quality bonds to obtain the BB rating. For this reason, investors should be knowledgeable and do their research before investing in such securities.