Generating yield on your savings may never have been more difficult, at least in the modern era. Money market yields now average just 3 hundreds of one percent, while CD rates for maturities of two and one half years or less are averaging less than ¾ of 1%. The old Treasury standby, 90 day bills, probably the most liquid and safest security on the planet, yields just 0.14%.
So, if an investor wants an annual $100,000 income and simply parks his nest egg in 90 Treasury bills for unparalleled safety and liquidity, that investor better have $71.4 million! Yet, even with all that supposed conservatism, you'd be losing purchasing power of more than $750,000 annually based on the last 12 months inflation (CPI of 1.2%).
Looking forward, if the Federal Reserve meets its goals, things won't be getting any better. It wants to keep interest rates exceptionally low for an extended period, while boosting inflation to 2% annually. A 2% inflation rate would cause that $71.4 million nest egg to lose over $1.4 million annually in purchasing power.
The fiscal side of Washington isn't going to make savers' lives any easier, either. That $100,000 in annual income is currently taxed federally at rates of up to 35%, potentially leaving just $65,000 to spend. If the Bush tax cuts are not extended, those highest rates will climb to 39.6%, potentially leaving just $60,400 after federal taxes.
Needless to say, investors have never had more incentive to find opportunities for more income. Unfortunately, where there's more return there's generally more risk, so investors must proceed cautiously.
One is credit risk, meaning default in timely payment of income or principal. Interest rate risk lurks, too; if you lock into a rate for a long term and rates rise, you will have lost the opportunity to take advantage of those higher rates absent a premature exit from your investment, undoubtedly at a loss.
Finally, investors should assess liquidity risk, meaning how difficult and expensive it might be to exit your investment. Obviously, selling a piece of real estate held for income will be far more costly and time consuming that selling your 90 day T bills.
Here are seven solid income ideas:
1. Short Term High Quality Bond Funds
Invest in, say, Vanguard's Short-Term Investment-Grade Fund (VSTFX) and you'll enjoy a yield of 1.75%. While many would sneer at that low return, it's still 58 times greater than the average money market yield. With over 1,000 issues in this professionally managed portfolio, credit risk is extremely low. However, the principal value will fluctuate, making it inappropriate for next month's rent money. Maturities are short, reducing substantially the risk of interest rates rising; a 50 basis point increase would shave just over 1% off your principal. Liquidity is excellent.
2.Municipal Bonds
This is the smart money's traditional income haven, and for good reason. These bonds have historically been of high credit quality; plus, the income is hard to beat when you start looking at what you'd have to earn on a comparable taxable income investment. The current yield on the Bond Buyer Municipal Bond Index is 5.26%. If that was paid out on a NJ bond to a NJ resident, a high bracket investor would have to earn about 8.76% to be left with the same amount after federal and state taxes.
Yet, concerns exist. Long dated bonds carry substantial interest rate risk; a 50 basis point rise on a 30 year bond could cause nearly a 15% drop in principal value.
Moreover, many states' budgets are troubled due to the Great Recession, prompting concerns about default. You can reduce your risk by diversifying across several states, although it may mean you'll have to pay state tax on your out of state bonds. Some experts believe that bonds to be repaid by essential services, like sewer and water, may entail less repayment risk than those simply supported by general taxes.
Liquidity is optimized and credit risk reduced by investing in a diversified muni bond fund, like Fidelity's New Jersey Municipal Income Fund (FNJHX), yield 2.83%; investors can generally come and go when they wish without transaction costs.
3.Treasury Bonds
Investors poke fun at Treasuries due to their low rates and conservative reputation. Yet, with the ten year Treasury yielding 3.02%, nearly 60 basis points more than as recently as early October, you're still getting about 100 times the income now found on your money market fund.
Treasuries carry no credit risk. They are the perfect antidote for a deflationary, recessionary, geopolitically risky world. The more exposed you are to risk assets like stocks and commodities elsewhere in your portfolio, the more Treasuries deserve a role. Put them in a tax sheltered account to avoid the bite of current taxes, and recognize that the longer the dated, the greater the yield, but the more severe the reaction should interest rates rise.
4.TIPS
TIPS is the acronym for Treasury Inflation-Protected Securities. It addresses one of the most pressing concerns of income investors: How to hedge inflation eroding income investors' real returns. TIPS principal value rises with inflation. As a Treasury security, credit concerns are nil.
These are best used in portfolios with little exposure to risk assets. Risk assets like stocks and commodities tend to benefit from inflation, so your need for a TIPS is less.
Some investors are leery of TIPS' use of the Consumer Price Index (CPI) as the gauge for inflation; the CPI is likely to understate inflation in such key areas as education and healthcare, while some believe this metric can be manipulated by the government.
Finally, for those needing immediate cash flow, TIPS may be a poor choice, as the current yield will be lower than a conventional Treasury's while the principal step ups due to inflation won't be received until redemption or sale.
5.Dividend Paying Stocks
With the average yield on the dividend paying stocks in the S&P 500 equaling 2.45%, income investors must consider them. After all, dividends have historically grown at a 5.56% annual clip; a $100 income payment would grow at that rate to $172 in ten years. That's compelling versus a static bond payment.
Your most attractive dividend rates are being paid by healthcare companies (3.3%), telecoms (6.1%), and utilities (4.6%). Of course, despite the lush payouts, their stock prices may sag, making them inappropriate for investors insisting on principal stability.
Dividends can be cut, and are not binding obligations. Amid this Great Recession, dividends on the S&P were slashed 21% on average, greatly pressuring dividend investors.
6.Build America Bonds
If you like munis but wish to invest via a tax sheltered account, consider "Build America Bonds," taxable debt issued by state and local issuers. Recent legislation promoted their issuance by committing the Federal government to reimburse their issuers by up to 35% of the higher interest rates demanded for taxable debt.
The good news for investors is that this typically very high quality debt yields substantially more than similarly rated corporate debt. This is partly because of a flood of new issuance due to fears the government may end its reimbursement program, and partly due to liquidity fears should that happen. Our advice is to take advantage of the higher yields, particularly if you can hold to maturity.
There's an exchange traded fund focusing on this asset class, Power Shares Build America Bond Portfolio (BAB), yielding about 5.4%. However, the average maturity of its holdings is quite long, 15 years or more for 87% of its holdings. Prefer shorter dated bonds if rising interest rates is a concern.
7. High Yield Bonds
They say that you can't get more return without more risk, so it's no surprise higher yielding bonds are generally issued by credit challenged issuers. High yield bondholders felt the cold winds of equity-like risk in 2008; a representative fund investing in this space, SPDR Barclays Capital High Yield Bond (JNK), dropped nearly 25% that year.
However, bulls on the economy forecast a general improvement in creditworthiness, making this asset class more attractive. Further, despite a furious rally in junk bonds over the last 18 months, high yield investors still make about 6% more over Treasuries of similar maturities, about in line with the long term average.
Junk bond investors are best advised to participate via a fund, in order to diversify away the risk of the bad apples. Mutual funds improve the liquidity of this asset class, too.
Further, consider how junk bonds would fit in your portfolio. The more risk assets you already own, the less reason to employ junk bonds. But, if you're primarily a high quality fixed income investor, junk bonds may offer you a hedge against a stronger economy; their greater income may help offset the inevitable higher interest and inflation rates that would cause havoc to high quality holdings like Treasuries.
David Dietze
Point View Financial Services, Inc.
382 Springfield Avenue, Suite #208
Summit, NJ 07901
Ph: 908-598-1717
Fax: 908-598-1777
Email: [email protected]
Web Address: www.ptview.com
So, if an investor wants an annual $100,000 income and simply parks his nest egg in 90 Treasury bills for unparalleled safety and liquidity, that investor better have $71.4 million! Yet, even with all that supposed conservatism, you'd be losing purchasing power of more than $750,000 annually based on the last 12 months inflation (CPI of 1.2%).
Looking forward, if the Federal Reserve meets its goals, things won't be getting any better. It wants to keep interest rates exceptionally low for an extended period, while boosting inflation to 2% annually. A 2% inflation rate would cause that $71.4 million nest egg to lose over $1.4 million annually in purchasing power.
The fiscal side of Washington isn't going to make savers' lives any easier, either. That $100,000 in annual income is currently taxed federally at rates of up to 35%, potentially leaving just $65,000 to spend. If the Bush tax cuts are not extended, those highest rates will climb to 39.6%, potentially leaving just $60,400 after federal taxes.
Needless to say, investors have never had more incentive to find opportunities for more income. Unfortunately, where there's more return there's generally more risk, so investors must proceed cautiously.
One is credit risk, meaning default in timely payment of income or principal. Interest rate risk lurks, too; if you lock into a rate for a long term and rates rise, you will have lost the opportunity to take advantage of those higher rates absent a premature exit from your investment, undoubtedly at a loss.
Finally, investors should assess liquidity risk, meaning how difficult and expensive it might be to exit your investment. Obviously, selling a piece of real estate held for income will be far more costly and time consuming that selling your 90 day T bills.
Here are seven solid income ideas:
1. Short Term High Quality Bond Funds
Invest in, say, Vanguard's Short-Term Investment-Grade Fund (VSTFX) and you'll enjoy a yield of 1.75%. While many would sneer at that low return, it's still 58 times greater than the average money market yield. With over 1,000 issues in this professionally managed portfolio, credit risk is extremely low. However, the principal value will fluctuate, making it inappropriate for next month's rent money. Maturities are short, reducing substantially the risk of interest rates rising; a 50 basis point increase would shave just over 1% off your principal. Liquidity is excellent.
2.Municipal Bonds
This is the smart money's traditional income haven, and for good reason. These bonds have historically been of high credit quality; plus, the income is hard to beat when you start looking at what you'd have to earn on a comparable taxable income investment. The current yield on the Bond Buyer Municipal Bond Index is 5.26%. If that was paid out on a NJ bond to a NJ resident, a high bracket investor would have to earn about 8.76% to be left with the same amount after federal and state taxes.
Yet, concerns exist. Long dated bonds carry substantial interest rate risk; a 50 basis point rise on a 30 year bond could cause nearly a 15% drop in principal value.
Moreover, many states' budgets are troubled due to the Great Recession, prompting concerns about default. You can reduce your risk by diversifying across several states, although it may mean you'll have to pay state tax on your out of state bonds. Some experts believe that bonds to be repaid by essential services, like sewer and water, may entail less repayment risk than those simply supported by general taxes.
Liquidity is optimized and credit risk reduced by investing in a diversified muni bond fund, like Fidelity's New Jersey Municipal Income Fund (FNJHX), yield 2.83%; investors can generally come and go when they wish without transaction costs.
3.Treasury Bonds
Investors poke fun at Treasuries due to their low rates and conservative reputation. Yet, with the ten year Treasury yielding 3.02%, nearly 60 basis points more than as recently as early October, you're still getting about 100 times the income now found on your money market fund.
Treasuries carry no credit risk. They are the perfect antidote for a deflationary, recessionary, geopolitically risky world. The more exposed you are to risk assets like stocks and commodities elsewhere in your portfolio, the more Treasuries deserve a role. Put them in a tax sheltered account to avoid the bite of current taxes, and recognize that the longer the dated, the greater the yield, but the more severe the reaction should interest rates rise.
4.TIPS
TIPS is the acronym for Treasury Inflation-Protected Securities. It addresses one of the most pressing concerns of income investors: How to hedge inflation eroding income investors' real returns. TIPS principal value rises with inflation. As a Treasury security, credit concerns are nil.
These are best used in portfolios with little exposure to risk assets. Risk assets like stocks and commodities tend to benefit from inflation, so your need for a TIPS is less.
Some investors are leery of TIPS' use of the Consumer Price Index (CPI) as the gauge for inflation; the CPI is likely to understate inflation in such key areas as education and healthcare, while some believe this metric can be manipulated by the government.
Finally, for those needing immediate cash flow, TIPS may be a poor choice, as the current yield will be lower than a conventional Treasury's while the principal step ups due to inflation won't be received until redemption or sale.
5.Dividend Paying Stocks
With the average yield on the dividend paying stocks in the S&P 500 equaling 2.45%, income investors must consider them. After all, dividends have historically grown at a 5.56% annual clip; a $100 income payment would grow at that rate to $172 in ten years. That's compelling versus a static bond payment.
Your most attractive dividend rates are being paid by healthcare companies (3.3%), telecoms (6.1%), and utilities (4.6%). Of course, despite the lush payouts, their stock prices may sag, making them inappropriate for investors insisting on principal stability.
Dividends can be cut, and are not binding obligations. Amid this Great Recession, dividends on the S&P were slashed 21% on average, greatly pressuring dividend investors.
6.Build America Bonds
If you like munis but wish to invest via a tax sheltered account, consider "Build America Bonds," taxable debt issued by state and local issuers. Recent legislation promoted their issuance by committing the Federal government to reimburse their issuers by up to 35% of the higher interest rates demanded for taxable debt.
The good news for investors is that this typically very high quality debt yields substantially more than similarly rated corporate debt. This is partly because of a flood of new issuance due to fears the government may end its reimbursement program, and partly due to liquidity fears should that happen. Our advice is to take advantage of the higher yields, particularly if you can hold to maturity.
There's an exchange traded fund focusing on this asset class, Power Shares Build America Bond Portfolio (BAB), yielding about 5.4%. However, the average maturity of its holdings is quite long, 15 years or more for 87% of its holdings. Prefer shorter dated bonds if rising interest rates is a concern.
7. High Yield Bonds
They say that you can't get more return without more risk, so it's no surprise higher yielding bonds are generally issued by credit challenged issuers. High yield bondholders felt the cold winds of equity-like risk in 2008; a representative fund investing in this space, SPDR Barclays Capital High Yield Bond (JNK), dropped nearly 25% that year.
However, bulls on the economy forecast a general improvement in creditworthiness, making this asset class more attractive. Further, despite a furious rally in junk bonds over the last 18 months, high yield investors still make about 6% more over Treasuries of similar maturities, about in line with the long term average.
Junk bond investors are best advised to participate via a fund, in order to diversify away the risk of the bad apples. Mutual funds improve the liquidity of this asset class, too.
Further, consider how junk bonds would fit in your portfolio. The more risk assets you already own, the less reason to employ junk bonds. But, if you're primarily a high quality fixed income investor, junk bonds may offer you a hedge against a stronger economy; their greater income may help offset the inevitable higher interest and inflation rates that would cause havoc to high quality holdings like Treasuries.
David Dietze
Point View Financial Services, Inc.
382 Springfield Avenue, Suite #208
Summit, NJ 07901
Ph: 908-598-1717
Fax: 908-598-1777
Email: [email protected]
Web Address: www.ptview.com
