Back in mid-October, I launched a new portfolio for income investors because I thought such investors could use some help in a very tough market environment. At the time, yields weren't very tempting: In fact, if you looked at the 4.5% yield on the 10-year Treasury note, they were downright disappointing. And as if that weren't enough, the Federal Reserve was firmly locked into a series of interest rate hikes well into 2006 that would knock down the price of any bond an income investor bought. Two months later, a lot has changed. But not for the better. The 10-year Treasury note still yields a low 4.5% -- 4.52% on Dec. 1, to be exact. But now there's even less reason to go long since, thanks to the Fed, short-term rates have moved up so that two-year and five-year Treasury notes yield almost as much as a 10-year issue. Furthermore, the Fed looks likely to raise rates two or three more times; consensus expectations call for an end to the rate hikes with the fed funds rate at 4.5% or 4.75% vs. the current 4%.
More Uncertainty in 2006But what happens after that is even more uncertain than it was two months ago. Will the Fed go on hold for the rest of 2006 after those presumptive increases? Or will the central bank be forced to actually reverse course and cut interest rates in the second half of the year as the economy weakens? Typically, when the yield curve inverts -- with short-term rates climbing above long-term rates -- as it is near to doing, it signals a potential economic recession. Outgoing Fed Chairman Alan Greenspan says not this time, but hey, he'll be playing tennis when this pudding gets eaten. So, right now, income investors are facing low yields, near-term rate hikes that will drive down the price of bonds and other income vehicles, plus increasing uncertainty about the direction of interest rates for the second half of 2006.
Yep, I guess it's time to offer up the rest of my 10-stock portfolio for income investors. For context, here are the first five securities in the portfolio and their current yields: Kinder Morgan Energy Partners ( KMP). Current yield: 6.4%. Northern Border Partners ( NBP). Current yield: 7.6%. Magellan Midstream Partners ( MMP). Current yield: 6.6%. Penn Virginia Resources ( PVR). Current yield: 4.7%. Natural Resource Partners ( NRP). Current yield: 5.1%.
Manage Risk and Get PaidThe name of the game right now, in my opinion, is: Managing the risk that interest rates, inflation or the economy will kick your income portfolio where it hurts, and... Getting paid decently for the risk you do take. With those principles in mind, I've divided the second half of my income picks into two parts. The first three are stocks that pay a bit more than market rate, and the risks are a bit less than for the fixed-income market as a whole. My last two slots are reserved for two ways to keep your money safe -- at the best return -- while you wait for either lower risk or higher yields as 2006 develops. Three stocks that I think pay you reasonably well for taking limited risks are: Southern California Edison Preferred (SCEDN:OTC). Companies looking to raise cash know that in an uncertain fixed-income market, investors are willing to pay a little more for certainty -- allowing the company to pay less to raise capital. This senior preferred stock from utility Southern California Edison, a unit of Edison International ( EIX), pays a face dividend of 5.35% -- or a current yield of 5.27% when the preferred traded recently at $101.47 -- which is a pretty low interest rate for an issue rated a relatively risky Baa3 by Moody's. But Southern California Edison was able to sell investors on this low yield by offering them a big chunk of interest rate protection. The initial yield of 5.35% is good until April 2010 and then resets quarterly at 1.45 percentage points higher than whichever is the greatest -- the three-month London interbank offered rate (LIBOR), the 10-year Treasury or 30-year Treasury. So after April 2010, you get a yield that's 1.45 percentage points above the highest yield on the curve, no matter if short or long rates are higher.
Because these shares are trading at a bit above par (or $100 per face value of the bonds), you do face some risk (about 1.5%) to your capital if the company decides to call these shares; they can call them in as early as April 30, 2010. But the company will call these preferred shares only if it can raise new capital at a lower interest rate. I don't know your long-term read on U.S. interest rates, but I see them moving gradually higher over the next decade as the U.S. trade deficit takes its pound of flesh. Of course, I'd like these shares even more if they were trading at par, and they have moved lower recently, so you might be able to solve this whole problem by waiting. (Many brokerages and research data basis use CUSIP numbers, rather than tickers, to identify preferred issues and bonds. To trade or do research on this one, plug the CUSIP number 842400756 into your broker's research or trading engine.) The Lehman Brothers Holdings Preferred Depositary Shares G Series (LEH-G) is structured so that an investor will do well if short-term rates continue to rise faster than long-term interest rates -- or even if the spread between short- and long-term rates just stays very, very tight. These depositary shares, which each represent 1/100th of a share of the company's floating-rate cumulative preferred series G shares, started off paying a minimum 3% dividend. But since that yield floats with short-term interest rates, it has climbed until the shares now yield 4.53%. The interest rate on these shares, payable in monthly dividends, floats so that it stays equal to the one-month Libor (currently 4.31125%) plus 0.75%. The initial 3% dividend is now the floor -- even if the Libor sinks like a stone, these shares will never pay a dividend of less than 3%. The stock is callable on Feb. 15, 2009, at $25 a share and recently traded at $25.18, a tiny premium to that call price. (While the shares may also use the ticker LEHPRG, use CUSIP #524908639 to research or buy shares.)
Rayonier ( RYN) is another way to combat the problem of uncertainty about the direction of interest rates. The stock doesn't give you the same blanket protection as the Southern California Edison preferred, but unless the economy really tanks, the degree of protection is quite good. Right now, shares of the timber company yield 4.6%. According to Value Line, Rayonier's dividends have grown by 11.5% annually over the last five years, and Value Line projects annual dividend growth of 18% annually for the next five years. That's a very solid upside on business as usual. If interest rates fall, not only will that dividend look pretty good, but the company's sales of timber and real estate should pick up. If interest rates climb because of inflation, the solid hard assets of the company's timberland should rise in value, too. Only if the economy tanks, taking earnings down no matter what interest rates do, will this stock suffer. I think that's a reasonable risk to take. (The stock has been part of Jubak's Picks since Jan. 7, 2005. I also own shares in my personal portfolio.) And here are my two picks for income investors who would like to earn as much as they can, while waiting for better yields or less uncertainty about the direction of interest rates: A 12-month certificate of deposit. No transaction costs. No interest rate risk. A very limited lockup on your money. Minimum investments from $1 to $5,000. And a current yield that ranges from 4.35% to 4.77% at the banks paying the highest rates, according to the most recent data on MSN Money. That's more than you get from a 10-year Treasury note (4.52%) or a three-month Treasury bill (3.96%). Your only real risk is from a big spike in inflation that eats away at the value of your capital. I don't think that's a very big danger over the course of 12 months; in my opinion, that risk is more than balanced by the opportunity to deploy your capital afresh at the end of 2006, when the interest rate picture is likely to be much clearer.
A six-month certificate of deposit. If you're really, really worried about inflation in the short run, go even shorter. The top 10 six-month CDs pay 4.18% to 4.50%, a very small drop from 12-month yields. Neither the 12- or six-month CDs are completely without risk. If interest rates sink markedly by the middle or end of 2006, an investor would be left to invest after the CD matured at a lower interest rate. I don't think that's a big danger, but make up your own mind on that possibility.