October 2010

October 2010: WHAT YOU NEED TO KNOW ABOUT - Investing For Income

Author: Lew Wessel | Photographer: Photography by Anne

The stock market is a big, bad scary place these days, and many of us just want to stick our heads, figuratively, under the covers by stashing our money into FDIC-insured money market funds and/or bank CD’s. Trouble is, of course, that the interest paid on these “investments” is barely worth the hassle of driving down to the bank and filling out the paperwork. Here are some alternative, relatively safe investments that you might want to consider.

In the financial universe, there is no reward without risk: The greater the risk, the greater the reward; the greater the reward, the greater the risk. Imprint this concept in your mind, and you’ll avoid virtually any scam and/or lousy investment dangled before you.

What exactly is “risk”? In financial terms, it’s normally defined as the deviation of actual returns of an investment from that investment’s average or expected return. This measure is called “standard deviation,” and the larger the standard deviation, the larger the “risk.” Over the long haul, say 30 years, this deviation is relatively small for all investments, including the most risky. This is why financial planners will generally encourage younger people to put most, if not all, of their investments in “risky” equities. However, over relatively short periods, say 10 years or less, the deviation from the norm can be substantial. As an example, the 100-year compound annual average return from 1909 through 2009 on the S&P 500 was 9.55 percent; but over the last 10 years, the compound average return has been 0.84 percent, with a standard deviation of 20.07 percent. Indeed, the annual swings have been wild in the last decade from a loss of 37.22 percent in 2008 to a gain of 28.72 percent in 2003.

A truly “risk-free” investment is one in which there is no deviation of actual return from expected return. This is exactly the case for an FDIC-insured, unrestricted money market fund, and this investment carries a commensurate low reward of about zero—actually one percent on average at Hilton Head banks, or $1 of interest per year per $1,000. Gives you goose bumps, doesn’t it? But that is the price for total safety.

So, making $1,000 per year on your million-dollar portfolio doesn’t cut it for you? Let’s look at some other possibilities for short to mid-term investments (e.g. 10 years) that will earn a little bit more for you with less risk than an all-stock portfolio.

Like FDIC-insured money market funds, these investments have no “default risk,” but they do have penalties if you try to cash-out before the maturity date of the CD. Nevertheless, if you are willing to “lock-up” your money for three months, the rate (per a few financial Web sites) will generally be about 0.5 percent; if you are willing to commit for five years, it will be around 2.5 percent—slightly better than the money market rate.

Note: Don’t be overly concerned about the $250,000 FDIC limit. Any bank officer will be happy to show you how you can easily and legally expand your coverage to almost any dollar amount.

Treasury bills (“T-Bills”) are issued in maturities of less than a year, “T-Notes” in maturities of two, three, five and 10 years, and “T-Bonds” for 30 years. “Treasuries” is a generic term for all three.

With a T-Bond or T-Note, you will receive interest every six months and the principal amount at maturity. A T-Bill is bought at a discount to its price at maturity (a year or less), and the interest earned is effectively the difference between the maturity and purchase price.

Currently, T-Bills of one-year maturity are earning a pathetic 0.26 percent. Two-year notes are at 0.54 percent, and even a 10-year maturity is earning 2.61 percent. A 30-year bond locks in a rate of 3.64 percent.

All three treasuries as well as *TIPS can be purchased through www.treasurydirect.gov or a broker, or, and this is probably your best bet, by investing in a mutual fund that specializes in these investments. The advantage of the latter strategy is nearly perfect liquidity (i.e. you can sell immediately if you have to) and also that you will typically receive interest payments on a monthly basis as opposed to semi-annually as is the case with an individual treasury.

Treasuries have no default risk. However, the longer out the maturity date, the higher will be the inflation risks. In addition, unless it’s held to maturity, a treasury’s price will fluctuate due to general market volatility, general interest rate trends and currency rate factors. A jump of just one percent in general interest rates can send the price of a 30-year T-Bond down by 15 to 20 percent.

*Treasury Inflation Protected Notes or “TIPS” are offered in 5-, 10- and 30-year maturities. As the name implies, they take inflation risk out of the treasuries by adjusting (upward only) the principal of the note by inflation; i.e. at maturity you will be paid the higher of the note’s original principal or its inflation-adjusted amount. In addition, the semi-annual interest rate paid is based on the inflation-adjusted principal of the bond, so it can increase as well (or decrease if we have deflation).

Unlike Fannie Mae and Freddie Mac, Ginnie Mae is actually a part of a government agency, HUD. Ginnie Mae notes, which consist of large pools of mortgages, are the only mortgage-backed security backed by the full faith of the U.S. Government. Thus, again, there is no default risk. However, there is interest rate risk, and there is also something known as prepayment risk, although that is probably not a major consideration now that mortgage interest rates are at historic lows.

Ginnie Maes are currently yielding about 3.5 percent and can be purchased for a minimum of $25,000 from a broker or, again, better yet, through a mutual fund.

Corporate bonds are basically business IOU’s—a corporation is borrowing directly from you instead of a bank. These bonds come in all shapes and sizes, all risk levels, wildly varying terms, etc. Frankly, unless you have a lot on money, allowing you to properly diversify, and a broker whom you trust and admire without reservation, I would suggest avoiding individual bonds and sticking with bond mutual funds or “closed-end” funds. The latter is a specialty area itself, but one which a competent broker can guide you through. Either type fund will help you diversify and thus reduce your overall default risk and will give you access to the expertise of the bond fund manager (usually a very large and well-paid team).

There is, of course, default risk with corporate bonds; after all, they can’t print their own money. As with individuals, the higher the assessment of the company’s default risk, the higher the interest rate the company will have to pay. In addition, because of both increased default and interest rate risk, the longer the company is asking to borrow money, i.e. the longer out the maturity date of the bond, the higher the rate.

A solid medium-term (average of three to five-year maturity), high-quality corporate bond fund currently pays about four to five percent, and interest is normally paid out on a monthly basis. These funds will fluctuate in value, but historically far less than equity funds.

These are IOUs from cities, school districts, states and other taxing authorities. Ditto on all the caveats mentioned above for corporate bonds. I’d also add that these bonds, on an individual basis, can be extremely “illiquid”; i.e. difficult to sell when you are ready. If you invest in one individually, be ready to hold it till it matures.

Municipal bonds, for the most part, are tax-free at the federal level and bonds issued by South Carolina and entities within (e.g. Beaufort County School District) are state-tax free for individuals filing a South Carolina tax return.

Municipal bond interest rates vary widely but are generally lower than comparably risky bonds because of the tax-free kicker. A bond fund that specializes in South Carolina municipal bonds recently sported a tax-free yield of about 4.2 percent.

This seems to be the hot investing theme of the moment, but buyer, beware! As many investors learned, painfully, dividends, unlike interest on bonds, are not “guaranteed”; they can be reduced or cut by a company’s board of directors at any time (can you spell BP?). In addition, in the event of a company’s demise, dividends and the underlying stock have the lowest legal standing and usually get entirely wiped out in the case of bankruptcy (can you spell CIT?).

If you are looking to juice up your current income via this group of investments, best to limit yourself to mutual funds or ETFs specializing in utility companies. Due to the stable nature of these businesses, these funds are generally less volatile then a fund that invests in a wide variety of dividend-paying companies. Expect current yields of four percent plus.

Wall Street is a marketplace that is perfectly attuned to the needs of “shoppers” for its financial products. The driving need now is for safety and income, two normally incompatible needs. I’ve touched above on some alternatives to a bank money-market account, but other income-oriented investments and strategies that you may want to explore, hopefully with your professional advisor, are preferred stocks, convertible bonds, covered calls, real estate investment trusts, infrastructure funds and energy-related master-limited partnerships. In all of your analysis, remember that the yin and yang of risk versus reward is ALWAYS in play. Best of luck.

To comment or for more information, e-mail lewwessel@hargray.com.

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