Low interest rates have become a major public enemy. And the Federal Reserve has pledged to keep rates deflated until 2014, which means the problem of generating adequate income will only persist. How can you get more income?
Chasing High Yields
Investing in bonds is a popular method for generating income, but many bond investors have strayed far away from their goal of “safe income” by increasing their risk.
The number of low cost exchange-traded funds or ETFs following exotic debt from Power Shares Emerging Market (NYSE:PCY) is growing. Although many of these countries have fast growing economies, they have less experience at managing financial shocks compared to developed nations.
Other bond investors are piling into lower quality debt to squeeze more yield or income from their investments. iShares iBOXX High Yield “Junk” bonds (NYSE:HYG) are high risk debt issued by corporations with a spotty credit score. It’s almost like lending money to your cousin Vinny who never pays on time, except when Vinny misses a payment, you can put a brick through his window because you know where he lives.
Some investors have increased their risk by extending the duration of the bonds they own.
For example, short-term Treasury bond ETFs like the iShares Barclays 1-3 Yr Treasury ETF (NYSE:SHY) and the iShares Barclays Short Treasury Bond ETF (NYSE:SHV) have a 12-month yield of just 0.77% and 0.07% respectively. These depressed yields have induced more than a few people to pile into iShares Barclay’s long-term U.S. Treasury bonds (NYSE:TLT), which carry yields in the vicinity of 3.40%. What they don’t know is that long-term bonds are more susceptible to price declines when interest rates increase along with inflation.
Bank certificates of deposit (CDs) are a type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. CDs carry federal deposit insurance up to $250,000 and the interest rate is generally fixed for a certain period. Despite these assurances, today’s CD yields aren’t high enough to earn investors any substantial cash flow.
Locking away your money in a 5-year CD at today’s average annual yield of around 1.41 percent is a sure way to lose the buying power if interest rates creep higher. Furthermore, it would take you approximately 49.5 long years to double your money at 5-year CD rates!
Parking money in a CD is the easy part, but taking it out can be another story. Many people forget the maturity dates for their CDs and are later shocked to learn that they have tied up their money for five, ten, or even twenty years. Some CDs will automatically renew at maturity if you do not withdraw your money. A lack of liquidity is another overlooked problem with CDs.
Top Yielding Sectors
Investing in high paying dividend sectors is another way to grab more income. Historically, investors have flocked to industry sectors like utility stocks Utility SPDR (NYSE:XLU), real estate investment trusts iShares Cohen & Steers (NYSE:ICF), and master limited partnerships (NYSE:AMLP).
This particular strategy has caveats. No matter how juicy dividends from individual stocks or sectors may appear, dividends are never guaranteed to remain the same and other hidden problems can suddenly arrive.
From 2004-07 investors were piling into high yielding mortgage iShares FTSE REITs (NYSE:REM) because annual yields in some instances had topped 16%. In 2008, mortgage REITs as a group sank 42% in value and shareholders in certain individual mortgage REITs were completely wiped out because their companies went bust. What kind of broken income strategy is that?
In this type of depressed interest rate environment, the smart income investors are employing other ways to generate income. They realize the traditional income sources alone are no longer cutting it.