Investing: Income Plays for a Low-Yield World

(page 2 of 2)

Remily agrees that income will become much more important to investors than share price appreciation during this time, partly due to stability. There's "scarcity value" in companies able to deliver growing income and investors will eventually recognize that value, while companies that don't provide a growing income stream will become less desirable, he says. Unlike fixed-income assets, stocks with a growing income stream will outperform when there's inflation as well as deflation, he adds.

Munis Passed Over

Municipal bonds, historically favored for their tax exemptions, are no longer much of a draw. The scarcity of supply relative to demand has significantly driven down yields and yield spreads over comparable duration, says James Sarni, senior managing partner at Payden & Rygel in Los Angeles. You'd have to go out to at least a seven-year maturity to be able to break even on munis compared with the yields on taxable bonds, he says.

Sarni prefers below-investment-grade corporate issues and recommends double-B-rated bonds maturing in three to five years, which represent the best tradeoff between maximizing yield and maintaining the value of your portfolio if and when interest rates rise, making your lower-yielding bonds less desirable. A four-year bond should be able to avoid a sharp price decline since, by the time interest rates are likely to start to rise a year from now, it would have only three years left to maturity, he says.

He likes Ford Motor's (F) single-B-rated bond that matures in 2013 and has a yield around 5.8 percent, and also favors Wynn Resorts' (WYNN) double-B-rated bond that is yielding 6 percent and matures in 2014.

Trust Preferreds

Trust preferred securities, which fall somewhere between corporate debt and preferred stock, are a relatively safe place to find yield during times of economic uncertainty, says Bill Larkin, portfolio manager for fixed income at Cabot Asset Management in Salem, Mass. They pay a fixed amount in interest quarterly, can be redeemed before maturity at whatever the market value is at the time, and mature at face value. Rather than trying to pick individual securities, investors would do better to buy the iShares S&P U.S. Preferred Stock Index (PFF), an ETF that represents the broad spectrum of trust preferreds, with a current yield of 6.92 percent.

When it comes to standard corporate bonds, Larkin believes the "sweet spot" are those rated triple-B-minus and double-B, with a three-year bond yielding around 5.5 percent, three to four times what a government agency bond yields. That "rate of return is somewhat in line with the risk you're taking," he says.

There are many companies with triple-B ratings that have solid business models, good free cash flow, and that will be around for decades, he says. Their yields tend to be higher because there are fewer buyers in that marketplace. Many mutual-fund managers are restricted from buying speculative-grade bonds, while high-yield bond managers view triple-B-rated bonds as too expensive compared with single-B-rated and even triple-C-rated bonds that offer higher yields, he says. Larkin focuses on bonds maturing in three to eight years, the steepest part of the yield curve.

"If we do get stagnant economic growth that the bond market is predicting, you're rolling down the curve" as the bond ages and the Fed stays on hold with interest rates, he says. "The bond's yield sticks out and it becomes a very attractive [asset]." You don't pay any capital gains if you hold these bonds until maturity and "you're getting a lot more stability than if you were invested in stocks, where people are questioning the return scenario."

Expert Picks

When he's confused about the direction of the market, Larkin says he lets expert bond managers at Pimco or Eaton Vance choose his investments. One example is the Pimco Income Fund (PONDX), an unrestricted, go-anywhere fund that buys bonds due to mature in three to 10 years, regardless of their credit rating. "Unrestricted is important today because of the crowded areas of the market," he says. "You want to make sure that management can avoid the pricey parts" of the market.

These managers are adept at identifying mispriced issues whose spreads have widened significantly due to adverse events in certain industries. They were able to exploit opportunities when the mortgage-backed securities market collapsed two years ago and probably found some good buys in Anadarko Petroleum's (APC) debt after the explosion of BP's (BP) Macondo well and the resulting oil spill in the Gulf of Mexico, he says.

Although higher-yielding assets clearly have elevated risk, the multiples are worth it, "especially if you believe the economic recovery is in place, which I do," says Larkin. Still, given the possibility of high default rates on debt, diversification through vehicles such as ETFs might help investors avoid some sleepless nights until the recovery is on firmer footing.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

Business Exchange

Track and share business topics across the Web.