Yield-Paying Instruments Could Grow in Popularity

Steve Eiting, an adviser and Primevest rep at Minster Bank in Minster, Ohio, had a client who received $350,000 from an insurance company accident claim.

Before the meltdown, Eiting would have invested most of the money in some diversified mutual funds or exchange-traded funds, with the balance in bonds. But the client was justifiably worried about market conditions.

So Eiting turned to yield-producing instruments, putting 30% of the assets in an investment-grade corporate bond fund and 20% in a municipal bond fund, both offering secure yields. He put 5% in a high-yield bond fund and another 5% in a high-yield muni fund for a little performance boost. To hedge against inflation, Eiting also invested 10% in Treasury Inflation-Protected Securities and 5% in a gold ETF. To grab potential stock gains, he put the remaining 25% in a balanced fund, including 5% in an energy ETF.

After last year's market collapse, many analysts see little likelihood of a further near-term jump, given the continuing recession and mounting unemployment. If the market turns south again, or merely treads water for a while, the best hope for most investors to increase assets may be yield-paying instruments.

The challenge for advisers is to find decent yields at acceptable levels of risk. This task is not as easy as it was last fall, but there are numerous options, each with its own pros and cons.

"Yields on just about everything have come down this year, but that's because people aren't in the panic mode of six to nine months ago," said Kent Wosepka, the chief investment officer at Standish Mellon Asset Management. "We're still seeing a lot of good value."

Those who had the guts to bet on debt last fall when most investors were running for safe havens could have done pretty well. "I had one client who bought a lot of GE and Genworth Financial bonds in early October last year, right at the height of the financial crisis," said Nate Wyatt, a Securities America financial adviser at Gothenberg State Bank in Gothenberg, Neb. "Both companies were double-A rated, but the market was worried about defaults. We got yields of 18% to 22% on these long-term bonds that were maturing in less than a year." Neither company went under, and the bonds, bought on the secondary market at a steep discount, paid out in full June 15. "This was a sophisticated investor," Wyatt notes. "I wouldn't have made that same investment for one of our" older clients.

Such prize pickings are gone now, but with the economy still limping, interest is still reasonably high at about 5.5% to 6.5% for triple-A bonds and over 9% for triple-B bonds.

"High-yield debt is still priced for Armageddon," said Jim Worden, a portfolio strategist at Iron Point Capital Management in Folsom, Calif. "Since we don't believe there will really be lots of defaults, we still see a lot of opportunity."

There are two big questions with corporate bonds, said Josh Gonze, a portfolio manager at Thornburg Investment Management. First, how worried is the client about interest-rate risk and inflation risk? That will determine the duration of the bonds. Second, how risk-averse is the client?

The best yields are noninvestment grade: triple-B-rated corporate bonds moved to about 3% over single-A-rated bonds by June, Gonze said.

Even for those with substantial assets, a bond fund may be better than buying individual bonds, he said. Bond funds can always be liquidated at net asset value, while individual bonds must be sold at auction. Bond funds also offer diversification.

"With individual bonds, even if you have $1 million to invest, you won't be very diversified," Gonze said.

For clients with high risk tolerances, advisers can venture further out on the yield curve with the Lord Abbett Bond Debenture Fund, which invests in distressed debt and in early June had a 9.25% yield, said Jeff Saut, a portfolio strategist at Raymond James.

For clients in lower tax brackets, many experts recommend Build America Bonds, a new product created by the Obama administration's stimulus program. Build America Bonds are taxable munis for which there has always been a small market. But these investments, which were created to encourage state and local authorities to start infrastructure projects, include a federal subsidy of 35% of the interest payments. Therefore, these bonds are less risky for investors.

BABs are issued by municipalities, school districts, public universities, sewer districts and other similar jurisdictions — the same types of entities that issue ordinary tax-exempt bonds. They come in a range of maturities and boast yields that often beat comparable corporates.

Unlike equities, yield-producing investments usually lock investors into current interest rates, which can look pretty puny if the country starts experiencing higher inflation.

Emerging-market bonds or funds are currently offering the same yields as Treasuries, but they also provide protection against a falling dollar. "We like the class, especially when not denominated in dollars, although the easy money has been made," said Patrick Kelley Galley, the chief investment officer at River North Capital in Chicago.

The obvious hedge is TIPS, where the invested principal and interest increases — and decreases — with the consumer price index, the main indicator of inflation. Advisers may want to keep clients' TIPS in a tax-deferred account, since any principal increases are payable in the current tax year, even if the TIPS mature much later. The same applies to TIPS mutual funds, where inflation adjustments are distributed and subject to tax annually.

Another option is stocks that pay dividends. "We see a lot of opportunity in dividend stocks and funds," said Iron Point's Worden. "We're not big on financials, which are dropping dividends, but lots of companies pay dividends. Even Microsoft and Cisco are paying 2%."

Lowell Miller, the president and chief investment officer of Miller/Howard Investments in Woodstock, N.Y., said, "If you look at history, it's always a good time to turn to dividend stocks. They have long-term returns and lower volatility."

Miller favors utilities, major telecom companies, both domestic and foreign, pharmaceuticals and consumer nondurables like Procter & Gamble and Johnson & Johnson, as well as master limited partnerships that own and operate petroleum pipelines — all companies that he said are likely to raise their dividends.

Looking for yield these days can be challenging, but with many economists predicting a long, slow recovery, the stock market may be the wealth maker it had been for quite some time. In this environment, advisers would do well to familiarize themselves with a wide range of alternatives on the yield side of the equation.

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Wealth management
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