For Income Seekers, There Are Alternatives

After the stock market’s 28-month slide, many weary investors now are much more interested in securities that generate regular income--a financial return they can count on.

But investors face a special challenge today: Yields on money market accounts are near 40-year lows, and interest paid on high-quality bonds is paltry.

The average yield on a taxable money market mutual fund is 1.33%, down from 1.59% at the beginning of the year, according to rate-tracking firm IMoneyNet Inc. in Westborough, Mass.

The yield on 10-year Treasury notes is 4.86%, down from 5.11% six months ago.

Meanwhile, investors who earlier this year took a chance on certain higher-yielding alternative investments, such as corporate “junk” bonds, have been burned.

Junk bonds have sold off sharply in recent weeks as investors decided the economy’s recovery won’t soon lift many of these “fallen angels.”

And emerging-market bond mutual funds, the top-performing bond fund sector until a few weeks ago, recently demonstrated their classic volatility when they plummeted on fears that Brazil will elect a leftist regime that will default on the nation’s debt.

As all this spurs income seekers to search far and wide for other ideas, options such as municipal bonds, inflation-indexed Treasury bonds and the “stable-value” funds found in many 401(k) plans look attractive to conservative investors, experts said.

The more risk-tolerant may want to consider high-dividend-paying stocks or mutual funds that invest in these stocks (such as real estate investment trust funds).

However, a cardinal rule of investing should remain uppermost in income seekers’ minds, said Alan Papier, a senior analyst with Chicago fund tracker Morningstar Inc.: “High yield is achieved only by taking on extra risk.”

The risk these days is not just of more bond defaults by shaky corporate issuers, although that’s clearly a concern. There also is so-called market risk: After 11 Federal Reserve interest rate cuts last year, the next direction for rates is almost certainly up, assuming the economy continues to recover.

And when rates begin to rise, the effect will be to depress the principal value of older securities that are locked in at a lower rate--especially longer-term bonds, including otherwise super-safe Treasuries.

For income seekers, that risk means investments must be chosen very carefully. You must decide whether you can stand any risk of loss to your principal, even on paper.

Here’s a look at some income-producing options other than money market funds, conventional Treasury securities and corporate bonds:

Certificates of Deposit

Although today’s bank CD rates won’t make anyone rich, they can keep investors ahead of inflation while they wait for better alternatives. And it does pay to shop around: For example, in Southern California recently, Kaiser Federal, a credit union-turned-savings institution, was paying about a percentage point higher on its CDs than comparable Treasury securities.

Newspapers and business publications often publish lists of high-paying bank and thrift CDs, but the most current rates are online: Bankrate.com, for example, lists top-paying institutions not only nationally but also by city and state.

Bank and thrift CDs are as safe as Treasury securities--up to the $100,000 per account limit on federal insurance. As with bonds, the longer you agree to lock up your principal, the higher the interest paid.

Recently, the highest rate on a one-year CD shown on Bankrate was 3.30% from ING Direct in Wilmington, Del. The national average on one-year CDs: 2.16%. If money market fund rates stay in their current 1.33% range well into next year--a strong possibility, many experts believe--CDs maturing in a year or less may be a better idea.

TIPS

The current 4.86% yield on conventional 10-year T-notes is at least a positive return after inflation, but that could change fast if the cost of living surges. Why can’t bond returns rise along with inflation?

The answer is that some do: Uncle Sam has issued bonds that guarantee a total return--interest payments plus return of principal--of about 3 percentage points more than the change in the consumer price index over time. If inflation shot up to 6% annually, the return on these Treasury inflation-protected securities, or TIPS, would rise to 9%.

“I wish I could get every grandma in America to own these things,” said Jeffery Coyle, chief strategy officer for MyCFO Inc., a Mountain View, Calif., financial advisory firm for the wealthy.

Because of their structure, TIPS are a good idea for generating income in tax-sheltered retirement accounts, Coyle said. Pimco Funds and Vanguard Group both offer large mutual funds that invest in inflation-protected bonds.

Stable-Value Funds

These funds, an option in many 401(k) plans, also are available through mutual fund companies in some individual retirement accounts and college savings plans. They usually hold so-called guaranteed investment contracts from insurance companies.

GICs essentially are fixed-income investments that sacrifice a small portion of return to purchase insurance against loss of principal.

Last year, 401(k) plan participants had 29% of their retirement assets allocated to stable-value funds, up from 25% in 2000, according to a survey of plan assets. The average return for the year ended May 31 was 5.95%, according to Hueler Analytics, a Minneapolis data tracker.

The returns have come down a bit lately--the Vanguard Retirement Savings Trust, for instance, currently offers a yield of 5.4% after expenses.

But for many investors, stable-value funds offer a solid income-producing asset that can cushion losses on stock assets.

“I think we’re seeing a sea change among investors,” said Gina Mitchell, president of the Stable Value Investment Assn. “It’s taken a couple of years to realize that 401(k) accounts can really go down because of overexposure to equities.”

Municipal Bonds

Municipal bonds--issued by state and local governments, often to fund roads, schools and other public projects--generally are exempt from federal income tax, as well as from state income tax for residents of the state in which they are issued.

The tax exemption means that the nominal yields on the bonds may be lower than what corporate and Treasury issues pay, but the true yield--the “taxable equivalent” yield--often is much higher. And the higher an investor’s tax bracket is, the greater the true yield.

Although a few local and state agencies fail to pay bondholders, the chance of default on a muni bond from a major issuer--say, the state of California--is virtually nil, said Zane Mann, publisher of the California Municipal Bond Advisor newsletter.

For investors looking to boost their income, and willing to accept the risk inherent in any bond, munis now are a smart option, especially given low Treasury yields, many financial advisors say.

Some California muni bonds maturing in 15 years are yielding about 5.25%, Mann said. That’s the equivalent of about 8% on a taxable bond for a middle-income investor and 9% for those in the highest tax brackets.

But remember: The principal value of long-term muni bonds (and long-term muni bond mutual funds) can fall sharply if market interest rates rise. If you own an individual bond and plan to hold it to maturity, that may not matter because all of your principal is returned at maturity. But it could be an issue if you had to sell the bond before maturity.

Also note that munis are a bad choice for retirement savings plans and college savings plans because you would be tax-sheltering a security that already is tax-sheltered.

REITs

REITs are companies that invest in real estate--such as hotels, industrial parks or apartment buildings--and pass most of their profit to investors. They’re an income option for people who can handle moderate risk, experts say.

The current average REIT dividend yield of about 6.75% is about 2 percentage points above the yield on 10-year Treasury notes, a typical spread for REITs compared with government bonds, said Craig Silvers, a former brokerage analyst who recently formed Bricks & Mortar Capital, a West Los Angeles REIT investment advisory firm.

But REITs are stocks, with all of the attendant risks: There is no guarantee of principal.

“Over the past couple of years REITs have been a good place to be, but should the real estate market turn down, you could get hurt,” said Morningstar analyst William Harding.

Because individual REITs target specific real estate sectors, investors must know what they’re buying.

Silvers’ current view is that the hotel sector is too volatile, shopping malls too unpredictable and the office building sector not ready to recover. But he likes REITs invested in food and drug shopping centers, as well as industrial properties.

Apartment REITs are attractive for investors who think the housing markets will remain strong, he said.

Although REITs are only about a fifth as volatile as the Standard & Poor’s 500 stock index, they are equity investments suitable only for investors willing to tie up their money for two or three years and who can tolerate some ups and downs in the stock price, Silvers said.

“This isn’t a place to park money for six months until you buy a house or a car,” Silvers said.

Another REIT option: mutual funds that own these shares.

High-Dividend Stocks

When share prices fall while corporate dividend payments remain the same, the dividend yields on stocks automatically rise. That’s apparent of late: Investors need look no further than the Dow Jones industrial average to find stocks with dividend yields that are higher than typical money market fund yields.

The annualized dividend yield on Philip Morris stock, for example, is 5.0%. (That’s calculated by dividing the annual dividend of $2.32 a share by the stock price, recently about $46.)

Eastman Kodak’s annualized dividend yield is about 6.3%; Du Pont’s is 3.1%; Exxon Mobil’s is 2.3%.

Those yields may be little consolation if the stocks continue to slide, of course. Kodak’s share price has fallen 33% over the last year.

Moreover, there is always the risk that a dividend could be cut by the company.

Still, dividend yields are a reminder that some stocks can provide at least a moderate income cushion.

Harding advises income-seeking investors to focus on companies that show a history of gradual dividend increases.

The search for consistent income can spotlight little-known companies such as Cedar Fair, an amusement park operator whose holdings include Knotts Berry Farm in Buena Park.

Cedar Fair, a partnership traded on the New York Stock Exchange, has increased its quarterly dividend payment from 20 cents a share in 1991 to 41 cents now, never missing a payout. The annualized yield is about 7.2% based on the current stock price.