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Searching for yield

In a world where money markets are paying 1.5 percent or less, and one-year CDs are paying an average 1.7 to 2 percent, what alternatives does an income investor have?

Reaching for very high yields almost always means accepting more risk. With that caveat in mind, I will go over some opportunities that look good now and provide some research tools to help you decide for yourself. To take advantage of these ideas it would be best to set up a brokerage account. Start with $1,000 or more.

If you like doing your own research, set up an online account using a discount broker. There are many quality ones. I have Fidelity and TDAmeritrade and Schwab. Each of these brokerages provides trades of any amount for under $10 and all have very good research tools. Other online and discount brokerages that are well regarded are Scott Trade and E*TRADE, among others.

Muni bonds

These are bonds issued by state and local government entities. They are tax-free at the federal level and, if issued by the state you live in, often tax-free at the state level. One thing to keep in mind about bonds – all bonds – is that if inflation picks up, bond prices will go down. In the current economic environment, my recommendation is that short- to mid-term maturities are best to reduce risk.

There is a choice of regular open mutual funds. Some will have a portfolio of bonds from many states. There are also funds that focus on one state, say California (CA), which will give double tax-free yields. But CA has had its share of fiscal difficulties, which means CA bonds are yielding more to reflect extra risk.

However, if you invest in a fund with many types of munis in it, the risk is quite low. Current yields for CA munis range around 4 percent double tax-free.

Tips

Tips are U.S. treasury bonds with a twist: they are designed to increase value over the term to keep up with the CPI. They are issued for 5-, 10- and 20-year maturities. I suggest the 5-year maturity that is currently paying 1.08 percent.

These securities can be bought through a broker but can also be bought directly from the government without commission. Go to http://www.treasurydirect.gov.

Currently, the 10-year Tip is paying 1.6 percent. With Tips, to get the full benefit it is wise to plan to hold to maturity. These should probably be at least a small part of everyone’s portfolio.

Now we move to securities with, perhaps, greater risk but the potential for outsized rewards.

Closed-end funds

Open-ended funds keep issuing new shares. Closed-end funds issue a set number of shares and no more. These shares trade mostly on the New York Stock Exchange. Since there are a fixed number of shares, the price on any day can be at a premium or discount to the underlying securities in the portfolio.

One of the best money-making ideas is to buy closed-end funds when they are selling at a discount to their asset value. The yield is based on asset value, not price, so if a fund yields 7 percent on its assets you could earn a lot more if the discount disappears. For example, closed-end muni bond funds are yielding 5 to 7 percent.

The yield and discounts are easily available. They are published weekly in the Wall Street Journal and Barrons.

An even easier way to learn more about closed-end funds is to go to http://www.cefa.com (the Closed-End Fund Association). There you can put in a symbol or scroll through the various offerings by type of fund, such as general equity funds, corporate bond funds, muni bond funds, foreign security funds and specialized funds.

I have a large position, for example in PEO (Petroleum Resources), which invests in natural resource companies. It is selling for an 11-percent discount and last year with capital gains and dividends distributed 10 percent.

I also own CHN and GCH, which are both funds that invest in China. Each was selling at a discount of 6 to 7 percent. Although last year was a bad year for China funds, they paid more than 10 percent in capital gains and dividends.

I also own Templeton Emerging Markets Fund (EMF) for diversification to the third world. One thing to be careful of in this uncertain economic environment is that some closed-end funds and ETFs use leverage. That means they borrow money to invest in more securities.

When the markets are rising, this tactic can juice returns. But when markets fall, it juices losses. My recommendation is to avoid leveraged funds at this time. You can check on the CEFA site. Click on the details of the fund and look in the lower right corner, where it will indicate leverage. No leverage will just show a dash.

Convertible bonds and preferred stocks

These are different entities but have some things in common in that they have a specified dividend and preferences to ensure that the dividend is paid.

Convertible bonds have characteristics of bonds and stocks. They are convertible at a specific price into the common but pay a declared interest rate. Because of the “call feature” the interest paid is less than a regular bond but has potential for greater rewards.

One way to play convertibles is through buying open-ended or closed-end mutual funds, which offer built-in diversification. One can buy individual converts as well.

In this difficult year for equities, I wish I had had an Apple (APPL) convertible. Since January, the common stock has gained 83 percent and convertibles near the conversion price track the stock price but provide a guaranteed interest payment.

Preferred stocks can be even more interesting. They pay a dividend rather than interest and many qualify for the 15 percent maximum dividend tax rate. Some are straight ‘preferreds.’ Some are convertible into common stock.

I hold CCT, which is a 7 percent preferred tied to Comcast, the cable and Internet provider. I also own AES C preferred, which is now paying around 7.5 percent.

Preferreds are usually issued at $25 or $50 per share but can trade above or below the issue price. Thus, AES C preferred is selling for $43 per share and the nominal 6.75-percent yield is really a 7.5-percent yield at the discounted price.

I also own Mid America Apts H series preferred, now paying 8.4 percent.

Blue chip stocks

Until the great recession, blue chip stocks paid very modest dividends. Now with stock prices still off about 30 to 40 percent, the dividends of these much-admired companies are looking pretty good.

My all-time favorite stock is JNJ, Johnson & Johnson of Band Aid and No More Tears brand fame, and pharmaceuticals such as Resperdal. It currently is paying 3.2 percent. But it was one of my first investments in 1984. Since then, with stock splits and dividend raises I am earning 20 percent on my original investment a year.

Such strong companies providing vital services and products as ATT (T) is paying 6.10 percent and Verizon, its competitor in telecom, is paying 6.4 percent. Their heavy infrastructure expenditures are largely behind them and they are raking in cash flow from wireless services and Internet.

British Petroleum (BP) is paying 6.1 percent. Does anyone doubt that oil prices will rise? Merck (MRK), the drug company, is paying 4.8 percent and has a strong drug pipeline.

CVX (Chevron Oil) is paying 3.7 percent and Home Depot (HD) is paying 3.2 percent. These yields are modest but they tend to compound as the company grows and this provides inflation protection.

Canadian Royalty trusts

Here is an example of “If it is too good to be true, it probably is.” The Canadian government is taking the punchbowl away from the party and is forcing the conversion of all Royalty trusts to corporations as of January 2011.

As taxable entities, some of the trust will be forced to reduce dividends. But that leaves a little over a year to collect fat yields. These require extra research. Some are planning conversion early and have promised they can maintain the dividend. Others may not fare as well.

The best way to research these is to get a list and go to their individual Web sites. Most are oil- and energy-related. These are best held in taxable accounts, since the Canadian government collects a 15-percent tax which can be rebated when you file your income tax return.

I own Vermillion Energy and Arc Energy. They are paying 7.5 percent and 6.4 percent. I will be watching carefully to see the fate of their dividends over the next year.

Shipping stocks, airline leasing, master limited partnerships and REITS

Shipping stocks traded on U.S. exchanges were paying me 10 to 15 percent per year. Some were dry shippers like Diana (DSX) and Paragon (PRGN), and some were oil tanker stocks like Nordic American (NAT) or Frontline (FRO).

As the economy deteriorated, shipping stalled even as more boats were being ordered. The result has been a perfect storm. All have reduced their dividends and many have eliminated them temporarily. If you want a lesson in volatility, Google the Baltic Dry Index graph. This is a graph that shows shipping rates for dry goods like iron ore.

However, I am buying more of these stocks, since they have hard assets that will be put back to use and the dividends will revive. But there is serious risk here. Airplane leasing stocks (I own AYR and GLS) are income vehicles that buy and lease planes to airlines. They still pay but have reduced dividends to save capital.

Somewhat less risky are Real Estate Investment Trusts (REITs), the darlings of the first half of this decade. But many are fallen angles now, ruined by taking on too much debt.

REITs own commercial real estate. For the better part of five years they often yielded 5 to 8 percent. It used to be a rule of thumb that REITs carried only about 40 percent debt to assets, but as credit was cheap, many binged on the drug.

General Growth Properties (GGP), now in bankruptcy, had debt exceeding 90 percent of assets, and just like homeowners who put little or no money down in the ‘go go years,’ they are in trouble. Still, some REITs, such as Simon Property Group (SPG), might be worth considering. Avoid any REIT with debt more than 50 percent of assets.

Master limited partnerships are intriguing at this time. They are pass-through entities that are not taxed at the entity level and distribute most of their income. Many are in the energy area.

My and Warren Buffet’s (good company to keep, I think) favorites are the oil and gas pipeline partnerships. They are toll-takers and are decoupled from the volatile prices of oil and natural gas. They get paid when product runs through the pipes.

Two I own are: Energy Products Partners (EPD) and Kinder Morgan (KMP). I also hold Penn Resource Partners (PVR), which mines coal, and Linn Energy (LINE). These pay from 7 to 11 percent and have held up rather well in the recession.

ETFS and structured products

Exchange Traded Funds (ETFs) are like mutual funds, but they trade on major stock exchanges so they can be bought or sold in less than a minute. They are made up of baskets of stocks or bonds that are intended to track a specific index or industry or part of the world like emerging markets.

I don’t invest in them because they are a bit opaque for my taste, since it is hard to research them or predict their yields.

Structured products come in many flavors. Acronyms include ELKS, CORTS and STRIDES. They are very odd animals but can be interesting to investors.

Until they were called this September, I owned Merrill Lynch APPL STRIDESE. They paid interest at 12 percent a year for two years and were linked to Apple Stock, which has nearly doubled in nine months in this tough economy.

To research them, see a broker or use the site http://www.quantumonline.com. It is free but you must register to get the tables and information. It has everything you need to do quality research by type of income security. Get familiar with this free site, as it can make you serious money and control your risk.

It’s apparent there are quite a few alternatives available to investors. Some that I have not discussed include annuities, which can provide guaranteed income for a lifetime.

Lesson from this quick survey of securities: there are higher yields but they come with some risks, but those risks may be worth taking at this time as the world recovers.

A security yielding 7 percent doubles your money in a little over 10 years. A security yielding 10 percent doubles your money in a little over seven years. One advantage to these is that they are very liquid and can be sold to raise cash quickly.

One watchword of good investing is “diversify.” One can do this with mutual funds that invest in stocks or bonds. One can do this with ETFs and also by parceling one’s investments over several industries.

Choose industries that are likely to do well and reward with dividends or interest as well as capital gains over the next three years as economies all over the world move out of recession into growth.

Writer’s note: This column is intended to spur you on to your own research or send you for a consultation with a broker or financial advisor. I am not a registered financial advisor. Any securities I have mentioned are ones I own and only serve as an example of the variety of income choices.

Margaret Singleton is a business and real estate analyst/appraiser with an MBA in finance. She can be reached at [email protected].

 

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