Houston, we've got a yield problem.

But exactly how big is it? And what can investors looking for higher yields do about it?

Anyone who has already retired knows the yield problem is real. Payouts on bonds, dividends on stocks, and interest rates on certificates of deposit are so low now that they're really putting the squeeze on anyone in retirement. Anyone who has rolled over a CD recently knows what I mean. Suddenly the $10,000 that was earning maybe 7.3% when you locked it up five years ago has to be reinvested at today's 3.6% rate. Whoops -- that cuts income from that investment in half.

But is this merely a warmup for a real yield famine that will strike when the entire baby boom generation starts to retire when it hits 65 in 2010? The demographic doomsayers believe it is. They argue that the retirement of the boomer generation will set off a massive flow out of equities and into fixed-income investments that will produce one of two unpleasant effects:

  • Depress stocks to a level that will make the recent bear market seem absolutely appealing.

  • Drive yields low, lower, lowest as everybody scrambles to safe income.

    If that second case is a description of the real extent of the problem, I think today's reasonably high yields on midgrade corporate bonds and the hefty dividends on some depressed common and preferred stocks are true bargains.

    In fact, today's yields might be investors' last chance to lock up a decent payout for retirement. Investors might want to consider snapping up bond issues like the Time Warner BBB+ rated 2023 bond yielding 8.13% issued by a unit of AOL Time Warner ( AOL). Or piling up shares of Duke Energy ( DUK) with their 5.5% yield -- or even better, buying American Electric Power ( AEP) for its 8% dividend.

    The Long-Term Yield Puzzle

    These are bargains so long as you keep in mind that the goals of fixed-income investing go beyond simply stuffing a portfolio with whatever instruments happen to be paying the highest yield right now. Fixed-income investments should also lower the volatility and the risk of the equity portion of a portfolio. And they're supposed to offer predictability of return to anyone planning for retirement. Any fixed-income strategy designed to respond to a potential yield famine in coming decades needs to keep these other goals in mind too.

    I wish I could be as certain about this long-term yield puzzle as those who believe this demographic scenario are. I certainly take the demographic facts seriously. The U.S. does face a huge retirement bubble in the coming decades.

    But the financial markets and the U.S. economy are complex systems in which the final results aren't determined by a single variable. We are, for example, at the end of an extraordinary 20-year period of falling interest rates built on, among other things, the willingness of vast numbers of non-U.S. residents to hold U.S. dollars and invest their savings in our financial markets.

    That puts some kind of floor on U.S. interest rates, because offshore investors won't be willing to hold billions and billions in our financial assets if the assets fail to pay a reasonable risk-adjusted return. (From a more global point of view, in fact, the assets controlled by retiring boomers do not represent the largest block of cash with power over the market.)

    The list of possible forces that could upset the doomsday yield scenario is lengthy. Inflation could kick up again in the U.S., for instance, as government deficits mount in the coming decade.

    The Certainty of Uncertainty

    But we don't know what will happen to the financial markets in the next decade. Many of the trends that ordered the 1990s have either ended -- such as the great bull market in stocks -- or seem to be drawing to a close -- like the great bull markets in bonds and in real estate. And it's not clear now what trends will replace them.

    So how should investors deal with this uncertainty? By building enough of the right kind of yield into your retirement portfolio so that you cut risk down to size.

    Here's how I approach the problem.

    Don't think about your retirement goal as a pot of money of a certain size. Instead, think of your goal in terms of retirement income. I know that most retirement planners focus on the size of the portfolio you'll need to retire with, but that's really just a way for the software or whatever to project how much income you'll have. Your heirs may care about the size of the nest egg you'll leave after you die, but while you're alive, it's the income thrown off by that nest egg that counts.

    Now there's an inverse relationship between the required size of the portfolio and the rate of return on that portfolio. If you need an income of $50,000 a year, you can do that with a $1 million portfolio that returns 5% or with a $500,000 portfolio that returns 10%.

    For most investors, the rate of return on the portfolio will be a combination of a yield derived from the portfolio's mix of fixed-income investments and the appreciation (plus dividends) from equities.

    Remember that, for retirement planning purposes, the returns from fixed-income investments and from equity investments have very different qualities indeed.

    Fixed Income Offers Stability

    Transforming the return from fixed-income investments into retirement income is relatively straightforward. $20,000 in bonds paying 8% a year produces $1,600 in income -- plus some potential capital gains in the bond if the market heads in the right direction. An investor in retirement can spend that entire $1,600 in income without dipping into capital or diminishing the income that investment will produce the next year.

    Stocks offer Complexity and More Appreciation

    Converting the return from equities into retirement income is not nearly so simple. Most of the return comes from capital appreciation and can only be realized by selling the equity or some portion of it. But deciding how much to sell so you don't reduce future income -- or, worse, outlive that income stream -- requires that you can project future gains from the equity.

    If I have $110,000 of Cisco Systems ( CSCO), I can sell $10,000 this year without reducing my capital -- if I know that Cisco shares will appreciate 10% next year. Since no investor really knows what the return on a stock will be next year, you usually deal with this uncertainty by reducing the number of shares sold for income. Conservatively, I might only sell $8,000 in Cisco shares. I might build that into my retirement plan by increasing the amount of money that I believe I need to save for retirement.

    High-yielding fixed-income investments, thus, have two advantages to anyone building or living on a retirement portfolio:

  • The high yield reduces the amount I need to accumulate for retirement.

  • The predictability of that yield -- compared with the lower predictability of the return from the more volatile equity investments -- also reduces the amount I need to save and invest to reach my retirement income goal.

    That leads me to the core of my yield strategy. I want to maximize two variables at the same time: The income produced by my fixed-income investments and the predictability of that income.

    Some Investments Don't Make Sense

    These goals rule out certain kinds of fixed-income investments right from the get-go. Bond funds are a poor match because the yield on a fund varies over time as bond fund managers replace older bonds with newer issues. And a good portion of the return from bond funds consists of capital gains -- which are as unpredictable for bonds as they are for stocks.

    Nothing against bond funds, mind you, but I think you should view bond funds as investments that compete with equities. You only buy a bond fund when its risk-adjusted return seems likely to exceed that in stocks, and when you want to reduce volatility and diversify a portfolio. They are not the best tools for attacking a potential yield famine ahead.

    Neither are high-yielding stocks where the high yield is a function of a severely depressed stock price and not solid cash flow devoted by management to paying a high and ever-increasing dividend. Remember, the goal is predictability of the high yield. A stock paying a high dividend because investors see management cutting the dividend is not a good match for a potential yield famine either.

    So what kinds of high-yielding vehicles is an investor seeking to hedge the possibility of a future yield famine -- and to reduce the amount that must be saved out of current consumption for retirement?

    Predictability and High Yield

    Among common stocks, I think the pattern is well established. The goal is a stock paying a high dividend currently -- high for a stock, that is -- but also where the company has a history of regularly increasing the dividend each year. That will help make up for the gap between the yield on common stocks and on corporate bonds. And where the company's finances give investors good reason to believe that the dividend is safe and likely to increase.

    With these criteria, I'd prefer Duke Energy with its 5.5% yield to American Electric Power with its 8% yield because the predictability of Duke's yield is so much higher. American Electric Power has paid out a dividend of $2.40 a share during a period when earnings came to just $2.06 a share. Duke paid out $1.47 during the 12 months when it earned $1.91. I think it's clear which company has more latitude to boost its payout and which dividend is more in danger of a cut or stagnation.

    Stick to BBB-Rated Bonds

    Issues rated near BBB -- in the current market -- seem to offer the best combination of yield and predictability for a retiree. Bonds with lower ratings may indeed show greater capital appreciation if the economy improves and the company doesn't go broke, but the default risk is also substantially higher. Extremely distressed bonds behave more like common stocks and don't offer the predictability of yield we want.

    I'd also look for issues that can't be called -- that is, purchased back from investors by the company at the original price -- for a long period of time, and that indeed have maturities far in the future. I'd also like to see the bond trading at less than its original face value so that I won't lose principal no matter what interest rates do if I hold to maturity. (When a company redeems a bond at maturity, it pays no more to investors than the original face value.)

    All things else being equal, I'd prefer the Time Warner 2024 maturity yielding 7.64% annually but priced at a 1% discount to its original face value to the Time Warner 2023 maturity yielding 7.71% but priced at a 15% premium to original value.

    And I'd prefer both those bonds to the Lucent Technologies ( LU) 2028 bond yielding 12% and priced at $58.56 per $100 of original face value, and the Level 3 ( LVLT) 2010 bond yielding 25% and priced at $38.18 per $100 of original value. That's not to say that these bonds aren't great capital appreciation plays -- if you can figure out the odds on survival -- but they don't have the predictability I want. Again, they're like common stocks.

    Preferred Shares and Convertible Bonds

    Finally, among hybrids of equity and fixed-income securities, look at preferred shares and convertible bonds. Companies who had to raise money during this bear market have had to offer investors some rather unusual vehicles to entice them to part with their cash. And some of those show exactly the combination of high yield and predictability that I'm looking for.

    Motorola ( MOT) issued something called a mandatory convertible preferred with the name Motorola Income Equity Secured Units. It trades under the symbol MEU. The preferred yields almost 9% and converts into Motorola common shares in November 2004 at what is right now a very attractive ratio. Corning ( GLW) and Alltel ( AYZ) also issued this kind of preferred under the symbols CGIJP and ALTEO, respectively. They were recently yielding 7% and 9%, respectively.

    Of course, with their conversion into common shares only a couple of years away in most cases, these securities don't meet my criterion for predictability, despite their juicy yields and potential for capital appreciation.

    Not Every Investment Is Perfect

    And these hybrids do give you a standard to use in measuring more conventional preferred stocks such as the 8% Preferred (ONE-V) of Bank One ( ONE) or the 6.5% Preferred (IKJ) of Bank of America ( BAC).

    It may take you a while to get used to some of these alternatives -- most stock investors aren't comfortable with bonds, let alone things like mandatory convertible preferred shares. But this market currently offers investors a wide variety of ways to address their fears of any potential yield famine.

    And, hey, along the way you might discover an investment that's potentially very profitable in a much more immediate time frame.

    Update to Jubak's Picks

    Thanks to this ferocious year-end rally, Amkor Technology ( AMKR) has climbed well over my $6 target price for May 2003 some four months early. The stock is up 111% in the last month and 218% in the last three months. On a fundamental basis, I think the stock is now fully valued -- and in fact has priced in a solid recovery in chip production well before there's much evidence of that turn in business.

    So I'm selling the stock out of Jubak's Picks with a 67% loss since I added it to the portfolio on April 2, 2002. Those of you who can trade more nimbly than I can in this format should note that the stock has moved from the bottom of its Bollinger Bands on Sept. 24, to the top, but still remains well below the 200-day moving average -- Amkor's sits at $9.79 a share -- that has provided resistance for technology stocks in recent rallies. (Full disclosure: Following the rules of Jubak's Picks, I will be selling my personal position in Amkor Technology three days after this column is posted.)
    At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Amkor Technology, AOL Time Warner, Corning and Lucent Technologies. He does not own short positions in any stock mentioned in this column.

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