Paltry payouts may have been bearable in exchange for liquidity and credit quality at the peak of the credit crises, when economic uncertainty was extreme. But now, with a recovery under way, default rates way down, and capital flowing, strategists say investors can do much better. Yields of 5% to 7% are attainable in assets such as emerging-market debt, senior bank loans and master limited partnerships, says Tony Roth, the head of wealth planning and investment strategies at UBS Wealth Management. Of course, investing for higher yields almost always means taking on more risk, he warns, "so we're recommending a combination of strategies."
Meanwhile, many investors in U.S. Treasuries and corporate bonds—for generations, among the most stable investments—might be underestimating their risk.
ince the start of 2010, $274 billion has poured into bond funds, while $35 billion has been pulled out of stock funds. The Federal Reserve's plan to pump $600 billion into the economy by next summer may keep rates down for six to 12 months. But when rates climb, the underlying values of bondholders' securities decline as demand shifts to higher-yielding issues. A 50-basis-point rise in rates—there are 100 basis points in one percentage point—could deal as much as a 9% blow to principal to folks in longer-term bonds, assuming that the holders sell them before they mature. The longer the maturity, the more severe the impact from rising rates.
"The world is topsy-turvy where risks are aligned," says John Tousley, vice president and portfolio strategist for third-party distribution at Goldman Sachs Asset Management. Contrary to what many investors assume, he says, "seeking more credit and global fixed-income exposure" will reduce the risk in an income portfolio, while adding diversification.
There are lots of higher-yielding alternatives to government and corporate bonds, but before plunging into them, investors should weigh what role each can play in their portfolios, says Andy Sieg, Bank of America Merrill Lynch's head of retirement services. Consider your income portfolio as made up of two buckets, he suggests: One to cover immediate and unavoidable expenses for the next four to five years; the second, geared toward generating income for longer-term, less critical expenses.
Volatile and riskier investments should populate the second bucket. In the first, play it very safe. Right now, that means aiming for a yield above 1%. That might not seem like a high hurdle—in fact, a yield like that would have been considered pathetic a decade ago. But the depressing reality is that average yields now are 0.03% on money-market mutual funds and 0.16% on three-month Treasuries. Bank money-market accounts offer more—0.65% to 0.94%, on average, depending on the size of the deposit.
But you can do better. American Express Bank is currently offering a 1.3% yield; WT Direct, a unit of Wilmington Trust, 1.21%. Ultra-short bond funds also offer somewhat higher yields, but they will temporarily swoon if interest rates rise, "so think of them as your second layer of liquidity for expenses nine to 12 months away," says Matt McGrath, a financial advisor in Coral Gables, Fla. Also, keep an eye on their underlying investments. During the credit-market collapse, many investors were battered by seemingly safe ultra-short funds that turned out to have significant exposure to toxic mortgage-backed securities.
The bottom line for income investors? Finding yield is tough, but there are still ways to generate a decent stream of cash, while tempering risk by keeping maturities to three years or less.
Consider the following:
EMERGING-MARKET DEBT
Bonds issued by emerging nations and denominated in local currency are the global fixed-income market's current sweet spot. These securities are tracked by the JPMorgan GBI EM Global Diversified Index, which has a 6.2% yield, says Jamie Kramer, global head of thematic advisory at JPMorgan Private Bank. "We strongly believe that the dollar will continue a secular decline and emerging-market currencies will appreciate," she says. "So you not only get more yield, you get currency appreciation too."
Kramer sees a far better outlook for this debt than for any other global debt, even though holders take on rate and currency risk and possibly government-stability risk, too.
To be sure, this asset class is three times as volatile as the Barclays Capital U.S. Aggregate Bond Index. But for anyone seeking to generate longer-term income, volatility should be less of a concern, Kramer asserts, especially because the fundamentals and growth prospects are solid.
She notes that emerging nations' debt, on average, equals about 33% of gross domestic product, versus 100% for the developed nations. And, she adds, GDP is expected to rise 5.6% annually in the developing nations, compared with less than 2% in the developed ones. "Finally, if you think about the allocation of institutional money, right now it's underallocated in emerging-market debt and equity," she adds. When more institutional money comes in, early investors should benefit from a rising tide.
FOREIGN GOVERNMENT BONDS
Debt crises in Ireland, Greece and elsewhere certainly have made some retirees unwilling to put their money into these securities. But these bonds, when prudently selected by an experienced fixed-income mutual-fund manager, can dramatically boost yields over what is produced by U.S. government paper, says Steven Enright, an advisor in River Vale, N.J.
For example, one-year bonds issued by the government of Australia recently were yielding 4.68%, compared with 0.28% for one-year bills offered by Uncle Sam. "You're getting nothing in certificates of deposit or Treasuries, so you do have to take some risk—going global involves measured risk," Enright says, adding that many global mutual funds yield 4% to 5%.
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