Thinking Outside the Cash Box: Take Advantage of Rising Rates

Cash alone won’t cut it as a lingering low-rate environment challenges income investing.

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The Fed remains in a go-slow mindset toward monetary policy. But make no mistake: Interest rates will continue to creep higher. Here are five ways to take advantage.

Saying interest rates will inexorably march upward is kind of like saying the sun will come out tomorrow (insert Annie lyrics). But to income-focused investors, what matters more is exactly when the sun will crack the horizon and whether they’ll be able to catch it at just the right moment.

When, and at what clip, rates will increase is hard to predict. This challenges investors of all ages, but especially those who are nearing or in retirement, to take a fresh look at income investing when alternatives such as dividend stocks are relatively pricey.

As the global financial crisis raged in late 2008, the Fed slashed its benchmark funds rate to a target range of zero to 0.25%. More than five years later, that target remains the same. That’s problematic for income-seekers, because almost every rate that matters is linked in some way to the Fed target.

In for the Duration?

If you’re investing in bonds, be mindful of duration risk—the price sensitivity of a bond as interest rates change over time—which could dramatically change your returns if you sell before maturity. Help is waiting.

Call the fixed-income desk at 877-869-2021 to discuss.

What to do? Making up for microscopic interest collected from bank deposits or money market funds requires a few more steps out on the risk-taking tightrope, as well as renewed emphasis on balancing that risk by dedicating a portion of your nest egg to a guaranteed income source, such as an annuity.

The good news is that Fed handicapping isn’t a complete shot in the dark. As the U.S. economy gradually improves, the central bank is still granting some wiggle room, applying a slow and steady draw-down in its monthly bond purchases (aka quantitative easing). Meanwhile, the funds target will likely remain near zero until 2015, Fed-watchers say.

That scenario leaves another traditional income investing category vulnerable. Buy-and-hold investors in corporate and government debt have to ponder whether bond prices are worth the added risk (remember, bond prices fall as yields rise, although investors still receive the bond’s coupon rate and par value if they hold to maturity).  

In other words, are yields sufficient to pay investors for exposure to longer-term risks, such as a pick up in inflation? We can say with some certainty that rates are going higher—that means future bonds undercut the value of current bonds. One also needs to be mindful of duration risk, which reflects the price sensitivity of a fixed-income investment to changes in interest rates.

1. DIVIDEND DIVIDE.

Not all dividend-paying stocks are created equal. When scouting dividend payers, it’s important to watch for dividend growth as much as, if not more than, current dividend yield, especially in a stronger economic growth environment.

If you feel the economic “risk” is to the upside (say, you think job market growth will outperform Fed expectations, or commodity prices and home values will surge), then you may want to consider the presumably discounted price of dividend stocks with smaller current yields. But you may want to select those with a strong history of (and continued potential for) raising their dividends regularly, as payment of stock dividends is not guaranteed and dividends may be discontinued. The underlying common stock is subject to market and business risks, including insolvency.

2. SELECTIVE BONDS.

High-yield bonds, which are ranked below investment grade by ratings agencies, have a higher risk of default but can serve as another means for an investor to diversify their fixed income holdings. Also known as “junk” bonds, these offer a higher return when compared to more conservative investment-grade counterparts, but investors need to be comfortable with the added risks, as they may not be suitable for everyone.

For instance, an average high-yield bond recently carried a yield about 4 percentage points above comparable Treasuries (the 10-year note yielded about 2.72% in late March). Careful selection is the key. The low interest rate environment allowed many companies to clean up their balance sheets. High-yield has outperformed the broader bond space over recent months, so valuation will be an important discussion point with your financial professional.

Also worth a look: Tax-exempt municipal bonds. So-called munis are issued by states, counties, cities or their agencies and interest is exempt from federal income tax. The tax equivalent yield on a tax-exempt muni can offer investors an attractive yield when compared to a fully taxable bond with comparable maturity.

As with any bond, investors should be comfortable with the issuer and its ability to honor its obligations; recent, high-profile financial troubles underscore this important point (Detroit’s bankruptcy, Puerto Rico’s debt downgrade to junk). Also, remember that municipal security interest may be subject to the Alternative Minimum Tax.

3. LAND GRAB.

Housing is expected to be a growth engine for the U.S. this year, even as borrowing costs escalate. One potential way to capitalize is through dividend-paying real estate investment trusts, or REITs. Purchased individually or through a fund, REITs typically offer investors relatively high yields, as well as a liquid method of investing in real estate.

Remember, some REITs are heavily concentrated on segments of the commercial market, such as shopping malls or office buildings. That makes them more vulnerable to economic swings. Also, this is an equity investment; there’s no guarantee of dividends or price appreciation.

4. STARTER HOMES.

We’re not talking about being a landlord—well, not exactly. The bullish housing theme may provide investing ideas for stocks, but it could also play another role in an income portfolio: mortgage funds. Consider the funds that own pools of government-backed home loans and pass interest and principal payments on to investors. These can be illiquid and subject to sharp price swings, so due diligence is required.

5. PIECE OF THE PIPELINE.

Master limited partnerships (MLPs) are a dividend-like investment with special tax considerations that allow them to pass some of their cash to investors. You’ll often see this type of animal among pipeline operators, which brings us to the U.S. oil and natural gas boom of recent years.

Pipeline MLPs basically collect a toll for transporting oil, gas, and refined products, which insulates them from short-term energy price swings but not longer-term supply and demand issues. MLPs have largely shrugged off a decades-old bad rap tied to the volatility inherent in energy prices; still, do your homework, as yields vary depending on the industry segment served.

BONUS IDEA.

Business-development companies are niche investments with REIT-like structures, meaning at least 90% of taxable income is paid out as dividends. These companies, which lend to or invest in small, growing, and sometimes financially troubled businesses, have filled a void that was previously the domain of regional development banks before the financial crisis. And, according to a recent Barron’s article, it’s the closest thing to a private equity fund the average investor can buy.

Business-development companies are niche investments with REIT-like structures, meaning at least 90% of taxable income is paid out as dividends. These companies, which lend to or invest in small, growing, and sometimes financially troubled businesses, have filled a void that was previously the domain of regional development banks before the financial crisis. And, according to a recent Barron’s article, it’s the closest thing to a private equity fund the average investor can buy.

There are several regulated, closed-end funds that allow investors to tap these firms. But keep in mind, we’re talking about something very different from your average blue-chip dividend stock.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.

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Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Investments in fixed income products are subject to market risk, credit risk, interest rate risk and special tax liabilities. May be worth less than the original cost upon redemption.

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