We've been here before. From early 2001 to mid-2003, the Federal Reserve responded to the tech-bubble collapse and the 9/11 terror attacks by gradually dropping its key federal funds rate from 6.5% to 1%. Yields on bank accounts and money market funds plummeted to meager levels. "Some clients would tell us how much they disliked Alan Greenspan," recalls Mark Wilson, vice president at the Tarbox Group, a wealth management firm in Newport Beach, Calif.
The Fed has a new chairman now, but Ben Bernanke seems to be playing the same tune in an attempt to get the economy humming again. Since last September, the fed funds rate has tumbled from 5.25% to 2%, reducing yields to savers. If clients are dissatisfied with the payouts on traditional cash equivalents, where can they turn for yield?
Not all planners think this is a valid question. "We believe in going for total return and not focusing on yield," says Glenn Frank, senior vice president and senior investment strategist at Wachovia Wealth Management in Waltham, Mass. "If something has a high yield, it likely will be offset by lower expected appreciation. A yield orientation often misses the target, due to some outdated and misplaced beliefs about money," such as the view that it's acceptable to spend interest and dividend income but not permissible to spend appreciation, he says. High-yielding vehicles make it easier for investors to reach their total return targets. This is the case for clients who are accumulating wealth and may not be too concerned about current yields, as well as those who are distribution mode and relying on investment income for cash flow. Either way, some high-yield instruments can help if they enable clients to reach their total return targets.
Nevertheless, high yields are important to many clients. What's more, accepting today's low yields on fixed-income vehicles may affect total portfolio performance.
"We might be heading into an era where yields will stay low, as they have for years in Japan," says Bill Van Keulen, head of operations at Carnick & Co., a financial planning firm in Colorado Springs, Colo. "If that is the case, it will be hard to reach investment targets of 7% to 8% a year for clients, using only traditional bonds paying around 4%. Planners need to be more engaged in seeking higher-yielding alternatives."
Yield can be found in a variety of places, from the most common to the highly esoteric. Here's a look at some of them.
Junk Bonds
Perhaps the most likely place to look for higher yields is in the high-yield bond market. Bonds issued by companies not rated "investment grade" are considered riskier, so they pay more to investors.
This is a good but slightly less than great time to invest in junk bonds, according to Chris Cordaro, chief investment officer at RegentAtlantic Capital, a wealth management firm in Chatham, N.J. "In March, we allocated 10% of our bond allocation to high-yield bonds after the spreads [between junk bonds and Treasuries with comparable maturities] rose above eight percentage points," he says. "Historically, when spreads are above eight percentage points, it's a great time to get into junk. Now, spreads are under seven percentage points, so high-yield bonds are not quite as appealing as they were.
"Investing in high-yield bonds when spreads are above eight points and selling when the spread drops to four points will produce average annualized returns of 15.5%," says Cordaro. "That has happened twice, starting in 1990 and in 2000. Spreads topped eight percentage points both times and stayed above four percentage points for four years, each time," adds Cordaro, who has, in the past, used open-end mutual funds when allocating to high-yield bonds.
The junk-Treasury spread fell to a low of 2.7 points in mid-2007, Cordaro says. Subprime mortgage woes and concerns about the economy brought the spread back over eight points last winter, so RegentAtlantic Capital decided it was time to jump into junk. To reduce the risk of this asset class, the firm opted to use diversified funds rather than individual bonds.
Cordaro recalls researching high-yield funds in early 2008. "We chose two funds after performing quantitative and qualitative analysis," he says. "Then we interviewed the portfolio managers and called the wholesalers to let the funds know we were making a large allocation in the next few weeks. One wholesaler came by a few days later to take us to lunch. At lunch, the wholesaler said, 'Wow, I am glad you chose our open-end fund, rather than our closed-end high-yield fund, which is selling at a 15% discount to NAV [net asset value].'"
After hearing this comment, Cordaro couldn't wait for the lunch to end, so he could check out closed-end high-yield funds. "Most were selling at large discounts," he says. "We realized that if we picked one or two for our clients, the discounts would narrow. Instead, we had Goldman Sachs put together a structured note that invests in a basket of 26 closed-end high-yield bond funds."
The Goldman note, called a Goldman Sachs Basket-Linked Note, is one that other planners can easily get access to-that is, planners who believe in having some money in junk bonds and are comfortable holding leveraged closed-end junk bond funds.
On average, the Basket-Linked Notes hold closed-end high-yield bond funds with a 9% discount to NAV, thus pushing up the yield. "Some of the funds use short-term borrowing to buy higher-yielding long-term bonds," Cordaro says. That also boosts the current yield on the notes.
"Since we bought those notes, more optimism about the economy has pushed up the price of junk bonds and reduced the spread over Treasury bonds below seven percentage points, giving us some gains already," Cordaro says. "Even with a spread below seven percentage points, junk bonds in general and these notes in particular may be appealing. "Our firm promised to invest $15 million," Cordaro says.
These basket-linked notes are not the only way to invest in junk bonds, of course. Among open-end high-yield funds, the average yield is now 8%, Morningstar reports. Van Keulen says that his firm has been buying BlackRock High Yield, which is among the lowest-duration high-yield funds, so it may be less volatile than others in this group if interest rates move up.
Municipal Bonds
Muni bonds are another asset class with attractive yields, although not quite as attractive as they were earlier this year. The benchmark Bond Buyer 20 Index of yields on long-term municipal bonds reached 5.1% in February, when tax-exempt yields actually topped yields on taxable Treasury bonds. As of mid-May, those average yields had dropped to 4.5%, about the same as long-term Treasury yields.
With equivalent yields, of course, most investors will wind up with more income, after-tax, from municipal bonds than from taxable bonds. "Our firm is buying munis with maturities out to 12 to 13 years," Van Keulen says. "Defaults for high-quality munis are next to zero." Therefore, those higher after-tax yields generally come with minimal risk. However, Wilson says that it pays to look at the underlying issuer's creditworthiness rather than relying on bond insurers, which have come under pressure recently.
In May, the Supreme Court upheld a state's right to tax out-of-state muni interest while exempting in-state bonds. Therefore, residents of those states that levy income tax who buy in-state muni bonds will be able to keep their double tax break-where applicable. One state that allows the double tax break is California, and Wilson often recommends state issues for clients who live there. In mid-May, Franklin California Tax-Free Income was yielding 4.57%. In contrast, Vanguard's Long-Term U.S. Treasury Bond Fund was yielding 4.55%, so a client in the top 35% state tax bracket would net less than 3% after tax.
REITs
Bonds are hardly the only assets that generate income. Stocks can pay dividends; with the S&P 500 down more than 10% from its October 2007 peak, dividend-paying stocks are yielding a bit more than they had been.
Among dividend-paying stocks, real estate investment trusts (REITs) may offer plump payouts. "The highest yielding investments we are currently using in client accounts are domestic REITs," Wilson says. "We had taken profits on domestic REITs after a long run-up, but we recently went back into them when prices fell."
At Wilson's firm, Vanguard's REIT Index ETF is among the holdings. This fund now yields around 5%. However, REIT payouts are often taxed at ordinary income rates, not the bargain 15% rate now effective for most stock dividends (0% for low-bracket taxpayers). Thus, REITs and REIT funds may work best when held in a tax-advantaged retirement account.
Preferred Stocks
Van Keulen says that some preferred stocks issued by financial companies are paying over 9%, but he's wary because such high yields may indicate commensurate risk. At slightly lower yields, though, he is finding some good values in preferred stocks, an ownership class that has a higher claim on a company's assets and earnings than common stock and that has characteristics of both fixed income and equities. "High quality, high-coupon preferreds with call features of three to five years can yield two percentage points or more over Treasuries," Van Keulen says. A call feature gives the company the right to buy back the stock at face value after a certain date.
Among the preferred stocks Van Keulen likes are Royal Bank of Scotland, ING Groep N.V., Aegon N.V. and Cenex Harvest States (now CHS Inc.), with yields ranging from 6.75% to 8%, a rate he believes is safer and more client-appropriate than 9%-plus some preferreds yield right now.
Preferred stocks tend to trade on their yields, so they do not have the upside potential of common stocks. "However, most of the preferreds we're buying are structured, so they pay qualified dividends," Van Keulen says. As mentioned, such dividends are taxed at no more than 15% under current law. Bond interest, on the other hand, is taxed up to 35%.
Balanced Funds
If some stocks and some bonds have decent yields, why not mix stocks and bonds in a common fund? That's the approach suggested by Susan Kaplan, a planner in Newton, Mass. "If you configure a portfolio of balanced funds, such as First Eagle Global, T. Rowe Price Capital Appreciation, Income Fund of America, Fidelity Balanced and Vanguard Wellesley Income, you will generate high income with growth potential and very low risk," she says.
Those balanced funds all yield less than 5%; some yield little more than 2%. Why own them, rather than buying some stock funds and some bond funds?
"Those balanced funds have real growth potential," Kaplan says. "Average returns for 10 and 15 years have been substantial, without a lot of volatility. Even in 2002, which was a terrible year for stocks, most of them did not lose money. Risk-averse clients who want income do not tolerate stocks or growth funds, but they do like balanced funds. They yield more income than regular growth vehicles. If more income is needed, balanced funds can be paired with bonds or bond funds."
Energy Plays
As the above comments indicate, the search for yield in today's market tends to focus on traditional asset classes: dividend-paying stocks and bonds that pay meaningful interest. Stretching for yield might mean investing in closed-end funds using leverage or trading at a discount to NAV.
Going beyond these norms, Van Keulen includes several limited partnerships in clients' portfolios, such as Plains All American Pipeline and TEPPCO Partners, which are pipeline operators, with current payouts in the 6.5% to 8% range. Because they are structured as limited partnerships, some of the distributions are treated as untaxed returns of principal. Those untaxed payouts eventually may be subject to income tax, when those holdings are sold.
