For investors who want their portfolios to generate income, getting the yields they need has become tricky—especially if they don’t want to take big risks. Interest rates still are near historically low levels, and when they rise in the next few years, as they are expected to, most bonds and bond funds will lose value, as they did last year for the first time since 1999. Also, many dividend-paying stocks have become less attractive because their share prices have risen so much.
But there still are ways to get yields of 2% to 3%…3% to 5%…and even higher if you know where to look and are willing to take on a little more risk.
Bottom Line/Personal asked two top fixed-income experts how our readers can get the best yields now…
For Conservative investors
Robert M. Brinker, CFS
Right now, conservative investors should stay away from Treasuries, mortgage-related bonds and long-term bonds, all of which are most likely to be hurt as the Federal Reserve continues to scale back its massive bond-buying program. I’m also avoiding dividend stocks for income because they present too much risk. Although dividends from a stable company such as General Electric have been yielding 3%, GE shares lost more than 50% of their value in 2008. A sharp pullback could happen again even with strong companies. Instead, I prefer the simplicity and diversification of bond funds whose managers keep their durations low (duration is a measure of bond’s sensitivity to interest rate fluctuations) and have the flexibility to find decent yields with low risks. My favorites now…
Yields up to 2%: Vanguard Short-Term Investment-Grade Fund (VFSTX). Investment-grade corporate bonds lost about 2% last year, on average, but this fund gained 1% and has lost money only twice in the past 31 years (–0.08% in 1994 and –4.7% in 2008). The fund has been exceptionally stable…has some of the lowest fees in its category…and is widely diversified among domestic and foreign holdings. Recent yield: 1.56%. Performance: 5%.*
Yields from 2% to 3%: Fidelity Floating Rate High Income Fund (FFRHX). This fund invests in securities that are similar to junk bonds but are safer because they have lower default rates. It buys loans that major banks have made to corporations with “junk” credit ratings, typically BB or lower. The yields on these loans are higher than ones from investment-grade bonds. In addition, floating-rate funds tend to do well in periods of rising interest rates because of another feature—the yields on their bank loans are structured to reset every 30 to 90 days, so if rates go up, you are not stuck with a lower-yielding investment. This fund takes a more conservative approach than its peers and has one of the lowest levels of volatility in its category. Recent yield: 2.59%. Performance: 8%.
Yields from 3% to 5%: Osterweis Strategic Income Fund (OSTIX). I’m avoiding many junk-bond funds because yields are at historic lows and not worth the higher risk of default. But this fund is a noteworthy exception, even though it is riskier than the two funds described above. Manager Carl Kaufman buys short-term junk bonds issued by companies that generate strong annual cash flow. That way he can be confident they can pay their debts over the next two years. The fund returned 6.6% in 2013 and 6.8% annualized over the past decade. Recent yield: 4.7%. Performance: 10.2%.
Greater Risks, Rewards
Investors willing to take on the risk of owning individual investments rather than mutual funds often can find much higher annual yields. But you need to look past conventional picks such as dividend stocks in the utilities and telecommunication sectors, which have become pricey. I’m finding more value in businesses that trade like stocks but have beneficial tax structures that require them to pass along most of their income to shareholders. My recent favorites…
Yields from 5% to 7%: Cheniere Energy Partners (CQP). Master limited partnerships (MLPs) such as Cheniere are corporate structures that are common in the energy sector. They trade like ordinary stocks, but in exchange for tax advantages, they must distribute most of their taxable income to shareholders annually in the form of dividends. Cheniere owns storage terminals, pipeline connections and liquefaction facilities for liquid natural gas exports from the US Gulf Coast. It has 20-year contracts with major energy players that ensure the stability of its dividend. Recent yield: 6.1%. Recent share price: $27.99.
Kinder Morgan Energy Partners (KMP). Another MLP that benefits from the boom in domestic oil and gas production, Kinder Morgan operates more than 37,000 miles of transport pipelines for oil and natural gas in North America. But what’s likely to keep its dividend rising are its massive land holdings in Arizona that contain carbon dioxide, which is essential to a new drilling technology. When the carbon dioxide is pumped into existing oil wells, it acts like a lubricant, greatly increasing the wells’ productivity. Recent yield: 6.7%. Recent share price: $79.48.
Yields above 7%: Campus Crest Communities (CCG). Like MLPs, real estate investment trusts (REITs) are required to distribute most of their taxable income to shareholders, typically from the rents they collect on their properties, which results in high, steady annual dividends. But unlike the shares of MLPs, shares of many REITs lost value in 2013 as investors worried that rising interest rates would make it more expensive for REITs to borrow capital in order to expand their real estate holdings. Campus Crest shares dropped nearly 18% last year, but I think it is a major buying opportunity even as interest rates continue to rise. The company owns about 80 residential properties near major universities, which have a chronic shortage of student housing. Recent yield: 7.5%. Recent share price: $8.83.
Compass Diversified Holdings (CODI). This holding company acts like a private-equity investor, acquiring controlling interests in established, highly profitable businesses that dominate niche industries. Example: Compass owns a company that makes premium safes for banks and another that supplies outdoor equipment, such as hydration packs and protective gear, to the US military and law-enforcement agencies. Recent yield: 8%. Recent share price: $17.95.
BlackRock Kelso Capital (BKCC). Business-development companies (BDCs) like this one are tax-advantaged companies that function as aggressive venture-capital funds. They make high-interest loans to small, private companies and startups, many of which have trouble getting conventional loans from banks. They also provide managerial expertise and sometimes take an ownership stake. If that sounds risky, it is, but many BDCs offer eye-popping dividends. BlackRock Kelso has stakes in nearly 150 companies, including kitchen supplier Sur La Table, American Piping Products, and Royal Adhesives and Sealants. Recent yield: 11.2%. Recent share price: $9.29.
*Performance figures are average annualized returns for the five years through January 31, 2014.