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Extra!
8 ways to earn 8% or more. Honest.
Even in this low-return world, you can find substantial yields without playing market roulette. Here's how.
By Jeffrey R. Kosnett and Courtney McGrath, Kiplinger's
Those 1% yields from money-market funds just don't cut the mustard. After taxes and inflation, you actually lose money when you invest at today's short-term rates. You would hardly do worse stashing cash under the mattress.
But what if we told you that there were plenty of income-producing opportunities that pay 8% or better and that don't require you to play the investment version of Russian roulette?
Intrigued? Keep reading.
First, on the subject of risk: There's no question that you have to stretch to achieve 8% yields in an environment in which the risk-free rate of return is 1%. As Jeffrey Gundlach, a bond manager for the TCW Galileo funds group, notes: "More money has been lost chasing yields than at the point of a gun."
To boost income, your goal should be to take prudent risks. Understand what you're buying, know what could go wrong and make sure you diversify among a variety of income-paying investments, including lower-yielding, lower-risk instruments.
Martin Fullenbaum, a 60-year-old physicist from Silver Spring, Md., seems to have figured it out. He recently added an unusual mortgage fund to complement the various property-owning real estate investment trusts (REITs) and growth stocks in his portfolio. He reckons that the 14% yield on Annaly Mortgage Management (NLY, news, msgs), which borrows at short-term rates and invests in mortgages, is more than enough to assure a positive total return, except in dire circumstances. "I'm aware that there is some risk, but I think the dividend is high enough that I'm okay with the extra risk," says Fullenbaum.
We've identified eight types of investments that yield 8% or better. They vary from the sort of higher-risk fund that Fullenbaum bought to preferred stocks issued by stable companies. They are listed in order of risk, starting with the safest.
Bank-loan bonanza
Does the opportunity to buy $1,000 worth of bonds for $900 sound tempting? A closed-end mutual fund can perform that alchemy. Unlike a regular mutual fund, which can issue an unlimited number of shares, a closed-end fund issues a fixed number. Those shares trade on an exchange, and you buy and sell them just as you would any stock. When you redeem a regular mutual fund, your price is the net asset value (NAV) per share. However, the price of a closed-end fund is based on supply and demand, and you can often buy closed-ends for less than net asset value.
As if closed-end funds weren't obscure enough, a narrow slice of that universe features funds that now generate yields upward of 8% with relatively low risk. The funds, run by such well-known companies as Eaton Vance, Nuveen and Van Kampen, invest in floating-rate loans that banks make to corporations that are either unrated or rated below investment grade. The objectives of these so-called loan-participation funds, says Nuveen managing director Ted Neild, are to produce yields midway between those of stable-value funds and high-yield bonds, but to do so with much less volatility than a typical junk-bond fund produces.
Banks typically charge these fragile borrowers an interest rate three to four percentage points above Libor, a benchmark short-term rate. But with Libor at a dull 1.4% now, adding four percentage points gets the yield to only 5.4%. The funds jack up their payouts by using leverage. For example, ING Prime Rate Trust (PPR, news, msgs) basically borrows at low short-term rates so that it can invest more money in the higher-yielding bank loans. At last report, leverage accounted for about 40% of the fund's total assets.
On the surface, this suggests potential for disaster should short-term rates turn up. But whereas the typical leveraged bond fund could get crushed in this scenario, a loan-participation fund should hold up. That's because the rates that banks charge corporate borrowers float, adjusting as often as daily. So in an environment of rising short-term rates, the fund's borrowing costs will rise, but so will the income it collects from borrowers. A more serious risk is that borrowers may miss their payments or declare bankruptcy. Then the market value of the loans would sink, denting a fund's NAV.
Launched in 1988, ING Prime Rate is by far the oldest loan-participation fund. Over the past five years to Dec. 2, it has returned an annualized 2% on NAV, according to Morningstar, while regular mutual funds that specialize in junk bonds have lost an annualized 1%, on average. ING Prime Rate has never lost more than 2% on NAV in any single year. (Return on NAV measures the performance of a closed-end fund's investments; the shareholder's return depends on swings in the fund's share price relative to NAV.) The fund, which consistently traded at premiums to NAV between 1996 and 1999, now sells at a 10% discount.
Because of increased demand by yield-hungry investors, ING Prime Rate shares have appreciated recently, causing its yield to fall just shy of our 8% threshold. Based on its latest monthly dividend of 3.8 cents per share, the fund currently yields 7.6%. But its shares bounce around every day. If you can snatch them at $5.70 (and assuming the dividend isn't reduced), you have your 8% solution.
High-yield favorites
Preferred stock is not, as the name might suggest, a superior version of common stock. Preferreds are so-called because their holders have priority over common-stock investors in certain matters, including dividends. More to the point, preferreds beat common stocks hands down when it comes to generating superior yields. Current preferred yields usually top 6%, while the average yield of companies in the Standard & Poor's 500-stock index ($INX) is a stingy 1.8%. Preferreds, on the other hand, don't have anywhere near the appreciation potential of common stocks.
In hard times, the senior status of preferreds can come in handy. A company must cut or eliminate dividends to common-stock holders before it meddles with preferred dividends. Firms suspend preferred dividends only when they're really on the ropes.
Preferreds, which pay a fixed quarterly dividend, behave a lot like long-term bonds, appreciating when interest rates fall and losing value when rates rise. Some preferreds are perpetual, which means that as long as the company exists, it must pay dividends. Like a corporate bond, a preferred stock may be callable. That means the issuer can generally redeem the preferred at its original issue price, usually $25.
The preferred stock of RenaissanceRE (RNR-A, news, msgs), a company that provides insurance to other insurance companies, yields 8% and is callable in November 2006 at $25 per share. The stock trades at a shade above $25, so you could lose a small amount of principal if it is called. Standard & Poor's gives the company an A+ rating. You can also invest in preferred-like securities that go by such acronyms as Quips and Pines. For example, there's a Stilwell Financial Pines (SVQ, news, msgs) preferred that sells for $25, yields 8.0% and is callable in April 2007 at $25. S&P rates Stilwell, parent of the Janus funds, BBB+.
Junk hunks
Since this is all about luscious income, we'd love to name a couple of sure-thing corporate junk bonds that would let you take down 12% or 13%. Alas, although we pressed the issue, bond dealers that cater to individuals insist that it's just not practical to buy a small slice of a junk-bond issue at anything resembling a fair price. It's also hard to research junk bonds. Besides, buying individual junk bonds entails more risk than the typical income investor ought to assume.
Clearly, mutual funds are the preferred method for buying junk. In exchange for paying an annual fee of 1% or so, you get professional management and diversification. Although total returns over the past few years have been drab, performance should pick up as the economy and the stock market improve. In fact, junk bonds should hold up much better than high-quality bonds if interest rates rise because of an improving economy. On the other hand, junk bonds usually sink in a weak economy.
One fund we've often recommended is Northeast Investors Trust (NTHEX), one of the oldest junk-bond funds. It sports a 30-day yield of 8.6%. Other no-load junk funds we like include Pimco High Yield D (PHYDX), TIAA-CREF High-Yield Bond (TCHYX) and Vanguard High-Yield Corporate (VWEHX). All yield about 9%.
Treats from REITs
Until last summer, traditional property-owning real estate investment trusts (REITs) represented an oasis in an otherwise arid market. But as vacancy rates ballooned at office parks, apartment complexes and other kinds of commercial real estate, the bear market finally caught up with REITs. Swooning share prices have an upside: They've goosed the average yield of property-owning REITs to 7.1%. With real estate as a whole facing harder times, a sensible strategy is to diversify by property type. "It's difficult to know when a particular commercial real estate sector will start performing better or worse," says REIT analyst Ralph Block of Bay Isle Financial, in Oakland, Cal.
Avoid REITs that are likely to cut their dividend. Look at the income statement and compare the amount paid in dividends to "funds from operations," or FFO, a common measure of a REIT's cash-generating ability (FFO is usually higher than reported earnings). If dividends eat up more than 90% or so of FFO, the dividend is at risk.
Block likes Tanger Factory Outlet Centers (SKT, news, msgs), which owns or manages 34 outlet properties in 21 states and yields 8.2%. Tanger's annual $2.45-per-share dividend consumes 73% of FFO. That's not too onerous. Another Block pick: Kilroy Realty (KRC, news, msgs), a Southern California owner of office buildings that yields 8.4%. Its $1.98-per-share annual dividend consumes 66% of FFO.
Wondering about real-estate mutual funds? Because of expenses and a focus on lower-yielding REITs, none comes close to our 8%-yield threshold.
Juiced-up muni funds
Allow us to cheat a bit in this category -- closed-end funds that invest in municipal bonds. They don't actually yield 8% -- at least not nominally. But interest from tax-free bonds (and bond funds) is exempt from federal income tax. So all it takes to equal what someone in the 27% federal tax bracket would earn from a taxable investment that yields 8% is a tax-free yield of 5.8%.
But achieving that high a tax-free yield, especially with high-grade munis, entails some extra risk. Closed-end bond funds often pump up yields by employing leverage. Their managers borrow money at short-term rates and use it to buy longer-maturity bonds with higher yields. The risk is that short-term borrowing costs rise, narrowing the spread between the funds' borrowing costs and the interest they receive on the bonds they buy. Or long-term rates could rise, reducing the value of the funds' bond holdings.
One attractive leveraged muni fund is Van Kampen Advantage Muni Income Trust II (VKI, news, msgs). Based on the fund's $14 share price, it yields 7.2%, or a taxable-equivalent 9.9% for the 27% bracket taxpayer (and more than 11% for someone in the 35% bracket). Its shares trade at a 4% discount to NAV. The fund returned an annualized 7.1% on NAV and, because of a narrowing of its discount, an annualized 9.0% to shareholders over the past five years to Dec. 2. The fund is about 40% leveraged. The average credit quality of the bonds is AAA and their average maturity is 15 years.
Or consider Scudder Municipal Income Trust (KTF, news, msgs). It's 36% leveraged and has nearly three-fourths of its assets in AAA-rated bonds. It returned an annualized 7% on NAV over the past five years and sports a yield of 7%, resulting in a taxable-equivalent yield of 9.6% for someone in the 27% tax bracket. It trades at a 10% discount to NAV.
Check Monday's Wall Street Journal for closed-end premiums and discounts. You can also get some data at the Closed-End Fund Association's Web site. (See link at left under 'Related Sites'.)
Fat oil dividends
You don't have to discover oil in your back yard to strike it rich in the energy patch. Instead, you can invest in a royalty trust. The typical trust yields 8% to 15%. Yields rarely drop below the bottom of the range except when oil and gas prices are depressed. If you hold one of these trusts for at least three years, you can generally outlast any temporary decline in energy prices.
Royalty trusts resemble REITs in two ways. One, they trade like stocks. Two, the trusts must distribute virtually all their income after expenses. Royalty trusts pay monthly or quarterly distributions, which tend to fluctuate based on the volume of oil or gas sold and the prices the commodities fetch. Because trusts have limited lives (wells run dry and, eventually, the shares can lose all value, although trusts can extend their lives by adding to proven reserves), distributions qualify for a depletion allowance. That lets you defer taxes on some of your dividends, although it adds to your potential capital-gains liability when you sell shares. Generally, the trusts provide detailed year-end tax information.
Russell Lucas, a Red Bank, N.J., money manager, is a fan of the trusts. "This is a rational structure," he says. "They pay legitimate dividends." Lucas, who has researched royalty trusts since the oil boom of the 1970s, says about 100 trusts, including some based in Canada, trade on U.S. markets. Canadian trusts may hedge against the possibility of lower oil and gas prices, which in theory makes their distributions more predictable than those of their U.S. counterparts (which may not hedge). But as with any energy investment, expect ups and downs on either side of the border.
Consider the record of San Juan Basin Royalty Trust (SJT, news, msgs), one of Lucas's favorites and a bellwether for the group. Since 1997, its annual payout has fluctuated between 64 cents and $1.72 per unit. Its share price, however, has climbed sharply from $3 in 1998 to about $14 today. And although the payouts in 2002 were lower than those of the previous year, San Juan's price still climbed 52% last year as investors snapped up high-yielding stocks. Based on the past year's distributions, the stock yields 5%, but with oil prices hovering at about $30 per barrel, there's a good chance payouts will rise in the coming year. San Juan, which has gas interests in northwestern New Mexico, estimates that its reserves contain about nine years' worth of production.
In addition to San Juan, Lucas recommends Enerplus Resources (ERF, news, msgs), current yield 13%, North European Oil (NRT, news, msgs), yield 7%, and Provident Energy (PVX, news, msgs), current yield 23%. You should study a trust's dividend and production history before investing. Avoid trusts if production is falling dramatically or the payout history has been inconsistent.
Generous corporate IOUs
The way the pros see it, you've got to be nuts to buy individual corporate bonds, except perhaps those issued by America's mightiest companies. They'll point out that WorldCom Group (WCOEQ, news, msgs) was rated AA not long before it imploded. But there's a reason that companies rated as low as BBB (by Standard & Poor's) or Baa (by Moody's) are considered "investment grade": The chances of investment-grade-rated companies failing to meet their obligations are extremely low. So looking into the lower rung of investment-grade bonds isn't reckless.
A BBB-rated bond puts you right at the 8% threshold. For example, Ed Markel, a vice president of J.B. Hanauer, a bond brokerage in Parsippany, N.J., points to a noncallable Motorola (MOT, news, msgs) bond (rated Baa2 by Moody's and BBB by S&P) that is due in 2025 and yields 8.5% to maturity. Motorola has problems, as its battered shareholders are painfully aware. But will it default? Unlikely. A bond maturing in 22 years a bit too long to wait? Hertz, with the same ratings as Motorola, has a bond due in 2009 with an 8.6% yield to maturity.
Of course, insolvency isn't the only risk with bonds. Inflation is the bane of any bond investor because it erodes the value of a bond's principal as well as its fixed-interest payments. A jump in interest rates, whether the result of rising inflation or other factors, will generally cause a bond's price to sink. Bonds are also vulnerable to announcements by rating agencies that they may downgrade the issuer. This can be particularly painful to holders of Baa or BBB bonds because a reduction would reduce their bonds to junk status. The mere prospect of a downgrade means "you can lose 10%, 15% or 20%" of principal, says Bill Hornbarger, bond strategist for A.G. Edwards. Check the Web sites of Moody's and Standard & Poor's (See the links at left under 'Related Sites'), or ask your broker if a company is under review for a possible downgrade. If it is, avoid it.
Buying individual bonds is trickier than buying stocks because the broker's commission is generally built into the bond's price. Markel says the markup for $10,000 worth of bonds (the usual minimum) runs about 1%. That compares favorably with a mutual fund that may extract that much per year for expenses.
Bountiful mortgages
With 30-year home-loan rates at about 6%, how do you get 12% to 15% investing in mortgages? A handful of unusual companies, legally structured as REITs, borrow at short-term rates and buy mortgage-backed securities from sources such as Fannie Mae and Freddie Mac. They then pay dividends from profits on the spread between their cost of money and the interest they collect on the mortgage securities.
This sounds as dry as can be, but it really isn't. Consider Annaly Mortgage Management, the stock that physicist Fullenbaum bought. Annaly's goal, says Chief Financial Officer Kathryn Fagan, is to pay three to five percentage points a year more than a long-term Treasury bond does. That would be 7% to 10%. Yet Annaly's stock yields 14%. The reason, says Fagan, is that the precipitous decline in short-term interest rates has boosted profits beyond normal levels. (As a REIT, Annaly must distribute essentially all earnings to shareholders.)
The big risk for shareholders would be a sharp increase in short-term interest rates, which would likely whack Annaly's profits. Annaly may use sophisticated hedging strategies to mitigate the damage of rising short-term rates. Still, a repeat of 1994, when these rates spiked from 3% to 6%, could be devastating. But there's as much of a chance that long-term rates will rise first, which would be a plus because it would mean a higher spread between short-term and long-term rates and even more profits for Annaly.
"These kinds of companies love the idea of flat short-term rates and rising long-term rates," says James Ackor, a financial-services analyst with RBC Capital Markets in Portland, Maine. He also recommends MFA Mortgage Investments (MFA, news, msgs), which sports a current yield of 13%. The share prices of both MFA and Annaly jumped sharply in 2002. Ackor says that both REITs' dividends and share prices may ease gradually over the next two years, but not enough to eliminate the extraordinary current yields.
--Reporter: Alison Stevenson
Safe Choices: Decent income without excessive risk
Given what's happened to your stock holdings the past few years, we know that lots of you just aren't in the mood to take chances. But you don't have to be a gunslinger to improve on money-market funds that yield 1%. These three types of investments all pay yields of close to 4% or better and still let you sleep well:
Stable-value funds. Long a fixture of 401(k) retirement plans, stable-value funds enter into contracts with other institutions that pay a guaranteed rate of return and seek to keep the value of the contracts constant. The contract's issuer, typically an insurer or bank, generally invests the proceeds in bonds. If the market value of the investments underlying a particular contract drops below the price paid by the fund, the contract's issuer promises to make up the difference. If the value rises above the fund's cost, the issuer pockets the difference.
The biggest risk: a contract issuer going bust. Even then, "funds can contract with up to 12 different issuers, so you wouldn't have much exposure to any one company's default," says Gina Mitchell, president of the Stable Value Investment Association, a trade group.
In recent years, fund companies have begun selling stable-value funds for IRAs and other retirement accounts. One no-load fund with an initial minimum requirement of just $500 is Scudder Preservation Plus Income (DBPIX). It returned between 6% and 7% in each of its first three full years of existence, and gained about 5% in 2002. Since the fund's late 1998 launch, its share price has never strayed from $10.
Short-term bonds. The shorter a bond's maturity, the less it fluctuates in response to changes in interest rates. Vanguard Short-Term Corporate (VFSTX) is a sound choice. It buys high-quality corporate IOUs with maturities of one to three years. Aided by a tiny expense ratio of 0.24%, the fund consistently shows up in the top half of its peer group. It yields 3.9%.
That old standby. Yields on certificates of deposit stink. But Uncle Sam insures CDs up to $100,000, and the highest yielders always pay a lot more than the average CD. You can get a five-year CD from Nova Savings Bank (877-482-2650) that yields 4.5%. The minimum investment is $500.
To see more or to subscribe, visit kiplinger.com.
© 2003 The Kiplinger Washington Editors, Inc.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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