There was a poll conducted recently of investors and financial advisors by a major brokerage firm, whereby four out of five advisors agreed their clients think primarily of bonds as the investment vehicle of choice for generating income. Investors on the other hand are concerned first and foremost with risk. Furthermore, two out of three investors surveyed felt that income investing today is much riskier today than it was several years ago!
That said there exist many income-generating opportunities that go beyond the traditional avenues of investing in bonds. Some of those opportunities are real estate investment trusts (REITS), master limited partnerships (MLPs), sovereign and emerging markets debt, high-yield bonds, bank loans, preferred equities and dividend-paying, large-cap value stocks.
Given that investors want to mitigate risk and generate income in a low-interest-rate environment, exploring these non-traditional avenues for income generation becomes necessary when you consider that money market and savings accounts essentially generate nothing, and certificates of deposits and U.S. Treasuries (depending on the length of time until maturity) offer less than 1% to 2% and hardly keep pace with inflation!
Let us briefly discuss some of these “non-traditional” income generating instruments.
Dividend-paying, large-cap value stocks
Common stocks may be out of favor because of the current economic climate, but there are many stocks in large, well-established companies that pay consistent dividends above 3%, offer future dividend growth and have the potential to appreciate in value!
These securities, often known as “hybrid” securities, share characteristics of both stocks and bonds, and they pay dividends that may be cumulative or non-cumulative in nature. They do not offer voting rights, but in the event of default by a company, preferred stocks are senior in claim to the shareholders of common stock but junior in claim to bondholders.
When looking at preferred stocks, make sure that you pay close attention to the credit quality of the company/issue in question. For instance, anything that is rated by Standard & Poor’s as BBB- is the “lowest investment grade” quality. Anything less than BBB- is regarded as “junk.” Also, these securities can be called by the issuer and some are “perpetual” in nature.
Additionally, be aware of the fact that the “call price” is usually set at $25 per share (the price at which the issuer may call the preferred from the holder) and many preferreds may sell at a premium or a discount to their call price.
Master limited partnerships (MLPs)
MLPs offer both attractive yields and dividend growth. MLPs are limited by United States Code to only apply to enterprises that engage in certain businesses, mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction and transportation. Some real estate enterprises may also qualify as MLPs.
To qualify for MLP status, a partnership must generate at least 90% of its income from what the Internal Revenue Service deems "qualifying" sources. For many MLPs, these include all manner of activities related to the production, processing or transportation of oil, natural gas and coal.
It’s possible, but rather unlikely, that the current tax treatment of MLPs could be challenged, which would obviously have a material impact on the prices and yields of MLPs.
Higher yielding corporate bonds
With the economy recovering (albeit at a snail’s pace) and highly accommodative monetary policy from the Federal Reserve, corporate bonds offer strong yields as well as low default rates; however, the default risk is generally higher than that of a government bond. Once again, you must be concerned with the credit quality of the issue.
An asset class similar to high-yield corporate bonds offering attractive income is floating rate bank loans. Bank-loan portfolios primarily invest in floating-rate bank loans instead of bonds. In exchange for their credit risk, these loans offer high interest payments. These type loans typically finance lower-rated companies and offer an interest rate that “floats,” or resets on a regular basis. The common benchmark used is the LIBOR rate or London Interbank Offered Rate.
Real estate investment trusts (REITS)
REITS are tax-advantaged entities that have historically provided attractive yields based on investment in real estate, rental payments income and capital gains from the disposition of properties.
There are different types of REITS (residential, commercial, etc.). One word of caution: when considering these type of investments, only invest in REITS that are publically traded as opposed to non-publically traded REITS, which are usually “illiquid” whereby your investment capital is tied up for a number of years.
Sovereign and emerging market debt
Because of the current European debt crisis, rather than being treated as a risk-free asset, governments now are treated as issuers with credit and default risk, with corresponding prices and yields that reflect such.
Emerging market debt also provides similar opportunities, with debt from companies in developing nations. Investments in either can also be further denominated in the local currency of the country in question or US dollar hedged. A word of caution here . . . . . to minimize exposure to foreign currency volatility, it is advisable to look at US dollar hedged investments.
The bottom line
Again when you consider that money market and savings accounts essentially offer nothing in the way of return and certificates of deposits and U.S. Treasuries little more, all of which do not keep pace with inflation, the above mentioned instruments offer very viable alternatives for generating steady income.
Clients today need to broaden their horizon when searching for income. Non-traditional, income-generating investments may provide that opportunity. However, do your homework before chasing yield. Remember the old adage, “there’s no free lunch!”
Thomas R. Kosky is a principal of the Asset Planning Group, Inc., in Coral Gables, Fla. The company specializes in investment, retirement and estate planning. In addition, Tom has also taught graduate level corporate finance in the Executive & Health Care Executive MBA Programs at the University of Miami in Coral Gables, Fla., for more than 20 years. Mr. Kosky welcomes your inquiries and comments. He may be reached directly at (305) 666-5198 or via email at TRKosky@aol.com.