7 Ways to Boost Investment Income

Quoted on
Fidelity.com (7.17.09)
7 Ways to Boost Investment Income
By Roger Fillion

With interest rates low worldwide, here are seven strategies to amplify the yield on your investments — with the risks and rewards of each.

The global financial crisis has forced interest rates close to zero on conservative investments like Treasury bonds as governments worldwide have moved aggressively to make credit more widely available.

But investors have other options in their hunt for a cushion against the bumps in the stock market.

Fixed-income investments other than Treasury bonds “today offer the best relative value in the market,” said Ford O’Neil, manager of Fidelity’s Total Bond Fund, with $9.7 billion in assets. “They’re the cheapest they’ve been in the past 25 years.”

The alternatives, all available through mutual funds, offer yields of up to 15% or so — compared to about 3.5% for a 10-year Treasury note. The opportunities are many, and the options vary depending on your risk tolerance. Some are definitely not for the faint-hearted.

“It’s important for investors to know the risks of the investments they’re making,” said Gibson Smith, co-chief investment officer at Denver mutual fund company Janus Capital Group.

Some of the investments that fall on the safer side include municipal and investment-grade corporate bond funds, as well as balanced funds that hold stocks and bonds. Moving up the risk ladder: Funds holding preferred stock; real estate investment trusts; and junk bonds and junk bond funds.

Income-producing securities may be more conservative investments than stocks, but they aren’t a sure bet. Accelerating inflation can erode the value of bond yields. Moreover, if the economy weakens further, there could be a jump in the number of companies defaulting on bond payments.

Experts advise a diverse investment mix. “It’s important for investors to figure out a yield mixture that represents a balance of different securities between ultra-risky and ultra-safe,” said Wes Moss, chief investment strategist at Capital Investment Advisors, a fee-only advisory firm in Atlanta.

“You want to think about the risk-reward trade-offs,” said Fidelity’s O’Neil.

Here are seven strategies for capturing higher yield, with an assessment of the potential risks and rewards for each category.

Municipal bond funds: These funds offer modest yields but also low risk and no taxes — making after-tax returns much more appealing for many investors. There is some risk that the cities, states and municipalities issuing the bonds to pay for roads, schools and other projects will default on their payments, but that risk is generally quite low. On the other hand, some states, notably California, are in serious financial straits. This means investors should tread extra carefully in this arena.

On the plus side, the income investors get typically is exempt from federal taxes although not necessarily from all state and local taxes.

“The yields aren’t fantastic. But they’re certainly better than Treasurys,” said Moss of Capital Investment Advisors, noting it’s relatively easy to find a municipal bond fund yielding 4% or more — a yield that’s north of 5% when you factor in the bonds’ tax-free status. On a tax-equivalent basis, that’s roughly 1.5 percentage points above the yield on a 10-year Treasury note. Yields for typical municipal bond funds range from 2.25% for short-term, high-quality funds to more than 6% for funds that invest in riskier securities.

Investment-grade corporate bond funds: These provide a relatively high yield with limited risk that the issuer will default. But if the economy sinks further or a big financial company goes bust, credit could evaporate and corporate bond defaults could indeed jump.

“We think it’s a good time for pretty high-quality corporate bonds,” said Todd Burchett, manager of ICON Bond Fund at ICON Advisers, a mutual fund company in Greenwood Village, Colo. Yields on investment-grade corporate bond funds range from about 5% to 8%.

Balanced funds: These funds, which typically invest in a mix of stocks and bonds, offer some of the potential return of stocks with some of the stability of bonds. One risk is that companies can cut dividends — more than 60 have this year, according to Standard & Poor’s. Also, Uncle Sam can boost taxes on stock dividends. Those are risks because these funds often invest in stocks with what look like solid dividend yields. In addition, there also are the normal risks of investing in stocks and bonds.

“I would suggest people look at a mixture of large-cap, U.S.-based dividend-paying stocks — especially those that sell into international markets — and high-quality corporate bonds,” said James Swanson, chief investment strategist at MFS Investment Management in Boston. Simple balanced stock-bond funds offer yields ranging from about 2% to 5%.

Convertible bond funds: Considered “cheap” by some investors, these funds offer the relative safety of corporate bonds plus the upside potential of stocks. Convertible bonds allow holders to convert their bonds into stock, and if they do, prices can fall.

“If the company does really well, you have the option of converting some of those bonds into common stock,” said Swanson, adding convertibles “right now are cheap,” with convertible bond funds yielding anywhere from 4% to 10%.

Preferred stock funds: These funds can throw off generous yields but also can get stung if the companies held in the fund go bust. Preferred stock has characteristics of both a stock and a bond: It pays a set dividend, and that payment takes priority over dividends to holders of common stock.

A note of caution: Expect volatility, and hope issuers don’t go belly-up. “You’re second in line behind the bondholders and secured lenders in the event of a default,” said Burchett of ICON Advisers. Yields on preferred stock funds range from about 7% to 12%.

Real estate investment trusts: Also considered inexpensive by some investors, these can offer a relatively high rate of return. But REITs also can be volatile since they are essentially real estate companies selling stock in themselves. REITs typically manage income-producing properties such as office buildings. Investors get shares and a quarterly payment representing a REIT’s income. You can invest directly or through a REIT mutual fund.

“People should at least begin to look at these as they tend to recover later in an economic cycle,” said Swanson at MFS.

Just how volatile can REITs be? One key index tracking this investment class — the MSCI U.S. REIT index — is off about 16 % so far this year.

Junk bond funds: Junk bonds offer high yield, along with a high risk the company issuing the bond will go broke. Junk bonds aren’t investment grade and are subject to big price swings. “They tend to act more like equities than bonds,” said Clint Edgington, president of Beacon Hill Investment Advisory, a fee-only investment advisory firm in Columbus, Ohio. One good option is a high-yield bond fund: A pro picks the bonds, and the holdings are diverse.

Experts advise investors to stay away from buying individual junk bonds. “I would argue that would be very risky,” said Fidelity’s O’Neil. He and others said that a junk bond mutual fund is a better option. Such funds currently offer yields ranging from roughly 8% to 13%.

So take your pick. But remember that while these alternatives can boost the yield on your investments, they don’t offer the safety of government Treasury bonds or other Treasury securities.

How much of your portfolio should be in these types of assets? That depends on your age, risk tolerance, overall mix and other factors. Your financial adviser or Fidelity’s asset allocation tool can help.