‘INCOME-ORIENTED OPTIONS FOR THE COMING YEARS,’ from Smart Money. GREAT READ on income investing. Looking for better yields vs. less than one per-cent on money market funds.

In Uncategorized on May 20, 2009 at 17:30

REGARDLESS OF WHAT happens in the stock market, the reality is that an increasing number of investors will be looking for income-oriented options over the coming years. As the baby boom generation continues to retire in greater numbers, more portfolios will be built around preserving principle and generating income rather than capital gain and thinking “long term.

Unfortunately, it’s very difficult to be an income investor now that the government is so blatantly gaming the system, borrowing massive amounts while forcing questionable lending through programs like TARP and TALF. Meanwhile, the Federal Reserve’s campaign of quantitative easing has pushed down interest rates for bank CDs and money-market accounts to almost absurdly low levels. According to the Money Fund Report, the 30-day average yield on money-market mutual funds now rests near 0.19%.

Income investing is somewhat foreign to me as it is against my nature and investment philosophy to buy anything simply for a yield. My belief is that you want to buy strong assets — period. Too often investors are lured to weak sectors or stocks because of their high yields, which mean nothing as the price of the underlying securities themselves decline.

Just as with equities, income investors must keep aware of the major prevailing trend. To that end, they must get in the habit of keeping an eye on the general direction of interest rates, a process made increasingly easy thanks to the myriad of indexes and ETFs that track various fixed-income benchmarks. Worth watching is the CBOE 10-Year Treasury Yield Index ($TNX.X), which provides a simple glance of the Treasury’s 10-year yield. Rates were as high at 8% in 1995 before dropping to 2% earlier this year.

A Further Fall for Rates?

CBOE 10-Year Treasury Yield Index (TNX)-15 year
CBOE 10-Year Treasury Yield Index (TNX)-15 year (30 = 3.0%, etc.)

Wherever you search for income, you can’t simply buy a bond fund and expect to collect above-average yield with no potential risk to principal. Just as with equities, however, risk can be mitigated through basic techniques such as appropriate position size and stop-loss orders, always aiming to cut losses short while letting winners run.

More than anything, avoid making large all-or-none allocations in a short period of time. Just consider the dramatic rally in stocks over just a few months. The same type of volatility, and shifts in trend, occur in credit markets — meaning that income investors must also monitor and alter their portfolios as market conditions change.

Here are a few of my current top choices for investors searching for yield within a diversified income-oriented portfolio.

Bank Loan Funds

Longtime readers will recall these were favorites of ours back in the credit boom, offering attractive yields and consistent price appreciation not closely correlated with other major asset classes. As the credit markets deteriorated, the buyout business, and leveraged lending in general, collapsed. Many investors became forced sellers as the markets froze. Bank loan funds were destroyed.

Now many are selling at dramatic double-digit discounts to their published NAVs, meaning that investors are able to buy assets for below their fair-market value. Of course, discounts in closed-end funds can persist, often for years at a time, especially in out-of-favor assets. But it’s hard to argue that investors who like a bargain aren’t getting one with funds like First Trust/Four Corners Senior Floating Rate Income II (FCT9.79*, +0.09, +0.92%), down 50% from 2007 levels, yielding 6% and trading 18% below its underlying NAV. Others to consider include Eaton Vance Senior Income Trust (EVF4.63*, +0.13, +2.88%) (8.11% yield, 12.6% discount to NAV), Eaton Vance Senior Floating Rate (EFR10.12*, +0.12, +1.20%) (8.28% yield, -9.08% discount to NAV) and First Trust/Four Corners Senior Floating Rate Income Fund (FCM9.35*, +0.10, +1.08%) (6.31% yield, 19.16% discount to NAV).

Moreover, if interest rates rise, bank loan funds could outperform as most hold loans that reset based on changes in short-term interest rates.

Foreign Currency Funds

Another idea for an income-oriented portfolio: currency funds, which provide diversification out of the U.S. dollar and, in some cases, a comparatively attractive income stream.

In an era of low rates world-wide, it’s hard to find high yields, even in emerging market countries, but some of the most attractive include CurrencyShares Mexico Peso (FXM77.99*, +0.44, +0.56%) (yielding 5.5%),CurrencyShares Russian Ruble (XRU31.14, -0.09, -0.28%) (yielding 4.15%) and CurrencyShares Australian Dollar (FXA77.88*, +0.26, +0.33%) (yielding 2.3%).

Also worth looking at is the newly launched WisdomTree Dreyfus Emerging Currency Fund (CEW20.68*,+0.14, +0.68%) we wrote about a few weeks back, which offers a basket of emerging market currencies, helping to diversify away from one country-specific risk. Keep in mind that the risk in these funds isn’t primarily interest rate, but currency: If the value of the U.S. dollar rises, these funds will most certainly fall.

For investors interested in combining currency risk and interest rate risk, foreign bond funds such as Templeton Global Income Fund, Inc (GIM8.29*, +0.10, +1.22%) (6.29% yield, -6.75% discount to NAV), Aberdeen Asia-Pacific Income Fund (FAX5.39*, +0.00, +0.00%) (7.87% yield, -5.15% discount to NAV) and Aberdeen Global Income Fund (FCO10.32*, +0.14, +1.37%) (8.55% yield, -2.19% discount to NAV) can also be considered.

Municipal Bond Funds

Many investors were shocked last year as their municipal bonds and bond funds, long thought of as the conservative ballast of their portfolio, actually lost money. Closed-end funds that use borrowed money were burned twice as badly, with price declines that far outweighed the income generated.

As risk appetite has returned, so has interest in munis, with many investors anticipating the higher taxes likely needed to pay for the dramatic jump in government spending. Value-oriented investors will also find bargains in closed-end muni funds, with many trading at notable discounts to NAV. On my short list in the sector are names likeWestern Asset Municipal Partners Fund, Inc (MNP12.12, +0.06, +0.49%) (5.45% yield, -12% discount to NAV), Nuveen Insured Municipal Opportunity Fund (NIO12.55*, +0.10, +0.80%) (5.85% yield, -9.6% discount to NAV), Nuveen Municipal Market Opportunity Fund (NMO12.18*, -0.02, -0.16%) (6.84% yield, -6.85% discount to NAV).

Because each person’s tax situation is unique, an investment in municipal bonds should be discussed with a competent tax professional.

Ultimately, the same philosophies we use while investing in stocks should also be employed when investing in bonds and other income securities. Given the historic uncertainties, especially in the credit markets, investors more than ever must approach the markets with a commitment to patiencediversification, and suitable risk.


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