How to Survive the Income-Investing Crisis - TheStreet

How to Survive the Income-Investing Crisis

Anyone living off earnings from savings, CDs or bonds knows the flip side of low interest rates.
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We're in the early stages of an income-investing crisis.

Low interest rates are great if you're buying a house, refinancing a mortgage or looking to buy now and pay much, much later.

Falling interest rates have put some pop back into stock prices this year and rewarded bond owners with total returns (that's interest payment plus price appreciation) of near 5% on 10-year Treasury notes and near 10% on corporate bonds.

And the

Federal Reserve

is betting that low interest rates are the medicine that will send economic growth rates above 3% and knock unemployment below 6%.

But low rates are a disaster for anyone who actually has to live on the income generated by savings accounts, money market funds, certificates of deposit and bonds. The Federal Reserve's June 25 move to drop its federal funds rate to 1% was the 13th cut in short-term interest rates in two-and-a-half years. Short-term rates stood at 6.5% when that process began.

A $250,000 portfolio invested just at that minimum interest rate would have earned $16,250 in interest income a year. Today, that same portfolio invested at the Fed's target rate would produce just $2,500.

Of course, income investors in five-year notes or five-year certificates of deposit have been sheltered from much of this drop. They won't feel the change in yield until one of these long-term investments matures and they have to roll it over. But imagine the potential income drop facing an investor who owns a five-year, 6.5% Treasury note that's about to mature. By locking in current low yields for 10 years instead of five, that investor can get a yield of 3.5% on a 10-year Treasury.

Conservative investors who kept their cash in short-term instruments such as CDs and money market accounts have already felt the pain. A year ago, three-month CDs were paying 1.81%. Now the yield is down to 1.02%. That's a 44% drop in 12 months.

And with the Fed promising to keep rates low until the economy shows signs of overheating again -- inflation, can you imagine? -- the crisis facing anyone trying to live on the income from a portfolio isn't likely to go away quickly.

So what should income investors do to get through this crisis? Let me handicap the pluses and minuses of the four available strategies.

Go Longer

That bond investor above who's thinking of buying a 10-year Treasury to replace a five-year note is an example of this potential strategy.

On the plus side:

Taking on a longer maturity will raise the income you get from a bond portfolio. The three-month Treasury bill yielded just 0.84% at the end of June, while the 10-year Treasury note yielded 3.51%. So, yes, an investor can lengthen the maturity of a portfolio to increase its yield. And if the Fed manages to appreciably drive down interest rates anywhere in the short term, it will be at the long end of the yield curve. The nimble bond trader might be able to pocket a capital gain.

On the minus side:

That investor is lengthening the maturity of that income portfolio at a 45-year low in interest rates. By buying a 10-year bond, you're locking in current low yields for the full 10 years. If rates start to climb, you could, of course, sell the bond, but rising interest rates will drive down the price of bonds. Most significantly, rising rates will drive down the price of long bonds.

Go Riskier

You can beat the 3.51% yield on the 10-year Treasury note by buying the 10-year bond of retailer

Target

(TGT) - Get Report

. In exchange for the greater risk that Target will go belly-up before the U.S. government does, investors are paid a yield of 4.25% on Target's bond. Take on more risk and the yield goes higher: The new 10-year notes offered by

General Motors

(GM) - Get Report

yield 7.15%, or about 3.6 percentage points above the yield on the 10-year Treasury.

On the plus side:

Taking on more risk will deliver a higher yield. And at the extreme end of the risk spectrum, junk bonds -- bonds that have earned a below-investment-grade rating from one or all of Standard & Poor's, Moody's or Fitch's bond rating services -- will also deliver equity-like returns from capital appreciation. That assumes, of course, that the economy gets better and any of the companies issuing these bonds gets a credit upgrade.

On the minus side:

Investors are taking on more risk and not being paid particularly well for it in absolute terms. General Motors' 10-year notes are indeed paying a hefty 3.6 percentage points above Treasury notes. (That difference is what's known as the spread.) But in absolute, rather than comparative terms, GM is still paying just 7.15%. That's not especially generous for a company with significant cash-flow problems over the next 10 years. And there's a lot of really, really risky paper out there in the bond market, and the supply is getting larger by the hour.

Eat Into Your Capital

Some financial advisers are telling clients to dig modestly into principal to replace lost income rather than take on more risk by potentially locking in low rates for a long period or taking on more risk. That's tough love: Most investors instinctively shy away from spending capital. But it's actually a trade-off between consciously deciding to reduce your capital by spending it and potentially reducing your capital by adding risk.

On the plus side:

You know exactly how much of your capital you'll spend to make up your income gap. That's better than risking difficult-to-estimate losses across your entire portfolio as you reach for higher yields. This is an especially attractive option if you think the yield opportunities and risks will improve significantly over the next year or two.

On the minus side:

It's obvious, isn't it? You eat into your capital.

Look for High-Dividend Stocks

The massive, decade-long rally in the bond market and 13 Fed rate cuts have reduced the yield gap between bonds and

some

stocks. For example, at a time when the

S&P 500

yields 1.64% and the 10-year Treasury 3.51%,

BP

(BP) - Get Report

yields 3.8%,

ChevronTexaco

(CVX) - Get Report

3.9%,

FPL Group

(FPL) - Get Report

3.6% and

R.R. Donnelly & Sons

(DNY)

3.9%.

On the plus side:

The dividends on stocks such as these will grow over time as management raises the dividend. So your actual cash income from this part of your portfolio isn't fixed. Also, many high-dividend stocks offer good protection from interest-rate increases and inflation, because it's likely that an economy that's growing fast enough to force interest rates up would be growing fast enough to lead to earnings growth at these companies.

On the minus side:

If these stocks have the potential to appreciate with an economic recovery, they also have the potential to fall in price. Many income investors aren't comfortable with the kind of volatility that can come with investing in stocks. Going forward, these types of stocks, with their substantial dividends, are likely to be no more volatile than bonds under many scenarios and much less volatile than bonds if interest rates and inflation kick up again in a couple of years. It's something to factor into your risk/reward calculations.

What It All Means

So which of these strategies should you use to get your portfolio -- and your life -- through this crisis in income investing?

All of them. In a mix that works for you and your circumstances.

For example, you might go long with part of your portfolio to increase yield by buying one of the guaranteed-principle bonds issued by

Bank of America

(BAC) - Get Report

and General Motors. These bonds, sold in small lots tailored for individual investors, have long maturities and so pay higher yields. But upon the death of the owner, the bond can be redeemed for its full face value by the owner's estate or heirs. That's protection against the erosion of your estate through higher interest rates or inflation.

Despite that protection, these bonds still lock you into today's lower interest rates, so you might want to mix them with a dose of high-yielding common stock. That gives you some exposure to any economic recovery and lets you participate in future dividend increases.

Retain some flexibility but still increase your overall yield by moving part of your cash from extremely short-maturity vehicles to something just slightly longer. So from a seven-day money market fund, go to a short-term government fund. The Fed has said rates aren't headed up soon, and I think it's reasonable to take the central bank at its word on this.

Add a dollop of credit risk by buying bonds of a company or two that looks like it's got a good chance to improve its balance sheet and perhaps its credit rating. Companies with good fundamentals but substantial debt loads are good candidates.

Waste Management

(WMI)

is an example.

That kind of approach requires a good deal of hard work and maybe even paying for more advice from a financial adviser than you're used to. I don't see a real alternative. I don't think there's a simple way out of this tight spot for income investors.

And if the Fed succeeds in bringing down long-term rates, the squeeze could get even worse.

Doing nothing and doing too much of the first thing that comes to mind are both easier. But I think both approaches will cost you money in the long run.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: BP. He does not own short positions in any stock mentioned in this column.