5 income investments to consider ...

... and 5 to avoid

By Lewis Braham

May 21, 2014 @ 10:11 pm EST

Ah, to be a rentier! Gone are the days when Vladimir Lenin could rail against these “parasitic” capitalists for “clipping coupons” from their bonds while doing no work at all. Nowadays, with 10-year Treasury notes yielding a mere 2.5% and junk bonds barely 5%, investors who want a decent stream of income have to scramble.

“All yields for almost every kind of security are at historical lows, for the most part,” says Ken Taubes, who oversees some $69 billion as chief investment officer of Pioneer Investments.

What are the yield-starved to do? Here are five income investments to consider — and five to avoid.

Consider: Municipal Bonds

The average A-rated 20-year municipal bond yields 3.4%. That's not great, but compared to what you get from 30-year Treasury bonds it's golden, if you're wealthy. For investors in the highest, 39.6% federal tax bracket, that 3.4% translates into a taxable-equivalent yield of 5.6%. If you're worried about credit quality, munis are a good option, because the default rate on them has been only 0.012% over the last 43 years. The Market Vectors Long Municipal Index (MLN) and the Market Vectors High Yield Municipal (HYD) ETFs yield 3.8%t and 5.2%.

Consider: Emerging-Markets Bonds

Economic instability in BRIC nations — Brazil, Russia, India and China — last year caused a significant downturn in emerging markets. “Emerging-markets corporate debt offers the best value in the bond market now,” says Nathan Rowader, manager of the Forward Income Builder Fund (AIAIX), which can invest in 13 different asset classes. “You're getting about an 8 percent yield.” Pioneer's Taubes also favors the asset class, investing in Indian and Indonesian government debt yielding over 8 percent. Credit quality is usually better than junk bonds in the U.S., which yield less.

Consider: Closed-End Funds

Let's say you owned a $10 bond that paid 50 cents of income a year — a 5% yield. Now let's say you could buy the same bond for $8 instead of $10. That 50 cents payout now produces a 6.3% yield. That's effectively what happens when you buy a discounted closed-end bond fund. Share prices of these funds move independently of their portfolio values, sometimes trading at discounts that amplify their yields. The First Trust/Aberdeen Emerging Opportunity Fund (FEO) currently has a 12% discount, which increases its 6.6% portfolio yield to 7.5%. You can find discounted funds at www.cefconnect.com.

Consider: Corporate Bond Trust Certificates

While most corporate bonds are overpriced, there are attractively priced ones sold directly to retail investors that trade like stocks. They're called corporate bond trust certificates. For instance, shares of Main Street Capital's bonds trade under the symbol MSCA and yield 6.1% at their $25 issue price. Although such bonds are usually unrated because they are from smaller issuers, they often have high credit qualities, says manager Richard Barone of the Ancora Income Fund (AAIIX). That's why 35% of his fund is in them. Institutions are oblivious to these small fry, so they have higher yields. Investigate them at quantumonline.com.

Consider: Preferred Stock

Many investors avoid preferred stocks because the traditional ones have very long maturities. The longer the bond's maturity, the more sensitive it is to rising interest rates. But Mark Freeman, manager of the $1.9 billion Westwood Income Opportunity Fund (WHGIX), has 12% of his portfolio in hybrid and floating-rate preferreds that avoid this problem. A hybrid preferred he likes from Wells Fargo (WFC-Q) has a fixed rate of 5.85% til 2023, then pays the prevailing interest rate plus 3 percentage points. A preferred issued by U.S. Bancorp (USB-H) has a floating rate with a guaranteed floor of 3.5%. You can find such preferred stocks at quantumonline.com.

Beware: High-Yield Bonds

Back in 2009, junk bond yields got as high as 20 percent. Today the $12.9 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG) yields just 4.4% after fees. “Historically, high-yield bonds trade more like stocks than bonds,” says Westwood's Mr. Freeman. “If that's my risk profile, my preference is to be in equities today.” The upside for junk when yields are so low is just the 5% yield, Freeman argues, while the downside from default is unlimited. By contrast, high quality blue-chip stocks pay 2% dividend yields and have unlimited upside and stronger balance sheets than junk issuers.

Beware: Treasuries/TIPs

If you're worried about the stock market, Treasury bonds should not be your safety play. Cash should be. The yield on the 10-year Treasury note is a paltry 2.5%; a 30-year bond, 3.4%. Any rise in interest rates will wreak havoc on Treasuries when yields are this low. Nor are Treasury inflation-protected securities a better alternative. TIPS are indexed to inflation and usually pay a “real” yield on top of that. But today the real yield is negative for short-term TIPS with maturities of less than five years and minuscule for longer-term ones. You're better off buying a savings bond.

Beware: High-Dividend Stocks

Back in 2006, value investing star Bill Nygren of the Oakmark Select Fund (OAKLX) boasted of how Washington Mutual had a 4.6% dividend yield. The bank consumed almost 16% of his $6 billion portfolio. When huge bets on subprime loans led to huge problems for WaMu, Mr. Nygren was blindsided. (The bank went into receivership in 2008 and its assets sold to JP Morgan Chase; the remaining holding company went into a voluntary Chapter 11 bankruptcy.) If a professional can botch a high-dividend investment, what makes you think you can get it right? Such companies are often over-leveraged and may cut their dividend the moment problems occur.

How high is high? The average stock in the S&P; 500 yields less than 2%. Utilities currently yield 3.7% on average, and real estate investment trusts 3.5%. These are securities that pay out most of their earnings as income. If you have an ordinary stock yielding a lot more than then, it's time to do some digging into the quality of that dividend. You're better off owning companies with strong cash flows and balance sheets to cover their payouts even if those payouts are less.

Beware: Real Estate Investment Trusts

REITs can be useful for income investors, but not now. The Vanguard REIT Index ETF (VNQ) has soared some 179% in the past 5 years and yields 2.62% after adjusting for worthless returns of capital. That's an incredibly low yield for a high-risk leveraged investment. While REITs can improve their dividends with earnings growth, growth rates in this sector rarely get out of the single digits. If you want real estate exposure, better yields can be found in REIT preferred stocks.

Why is that return of capital worthless? Because it's just the return of capital you invested in the company -- no new money was earned from that investment. You can think of it like this: If you invested, say, $10 in a company and it paid out $1 in a return of capital, it would look like a 10% return to a novice investor. In reality, the business would now be worth $9 instead of $10. It's like giving the company a dollar and having it give that right back to you and call it a dividend.

Beware: Master-Limited Partnerships

Like REITs, master-limited partnerships were a good income idea that has since been played out. These securities that pay out the income stream produced, often, from natural gas and oil pipelines have had an incredible run. The Alerian MLP Index has delivered a 221.7% total return in the last five years. The sector now yields less than 5% on average. “The opportunity in MLPs is limited now,” Mr. Freeman said, “but longer-term I love the asset class.” Mr. Freeman thinks the growth prospects for MLPs are better than those of REITs, so eventually those dividend yields may go up. Wait for that.

This story ran first on Bloomberg.com.

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