Like most people, you are probably looking for higher returns. People who depend on investments to provide retirement income are going to find that especially difficult after the Fed’s recent announcement that interest rates are to remain close to zero for the foreseeable future. With 10 year treasuries paying less than 2% and 5 year CDs paying less than 1%, it is often a necessity to look for alternatives. Here are 7 of the most popular income investment alternatives – and what you need to know about each.
1. High Dividend Stocks
What is a dividend? It’s simply a payment to you by the company you own. Stocks that pay high dividends can seem like manna sent from heaven. And there are many quality companies that pay dividends much higher than the 10-year treasury. That attractive income coupled with the upside potential of owning equities has its allure. Equity income stocks raked in over $30 billion last year. That was the second highest of any fund group according to Lipper Inc.
What to be aware of.
If you buy high dividend securities, make sure to invest in stocks that can continue to pay those high dividends. Read the shareholder letters and financial reports. Look for companies which are increasing dividends – and have a long history of doing so. Also, understand the firm’s cash flow statement to be sure the cash that is being used to pay those dividends is coming from operations and not the sale of assets. But be wary if the dividend is extremely high. Those stocks can be excessively risky.
2. Master Limited Partnerships
What are Master Limited Partnerships? MLPs are companies involved in the transport of energy. They pay high dividends and in some cases they offer tax breaks. What’s not to like? Glad you asked.
The problems with MLPs.
First, the tax code could change and drive these investments out of favor. Next, the price of energy could actually drop. If that happens, the profits may evaporate as will the juicy dividend. And to make matters worse, if the dividend is suspended or decreased, the share price will likely sink like a w0olly mammoth in a tar pit. Double whammy.
3. Debt of Emerging Countries
In many cases, emerging market debt is really junk bonds. But not all emerging market debt is. Some of these bonds are secured and issued by very strong companies. Take a close look.
In addition, you can invest in debt that is pegged to the dollar or pegged to the local currency. If you go with the local currency, your bonds will perform better if the dollar slides in value. On the other hand, you might get your head handed to you if the dollar strengthens. Since both dollar denominated and local currency denominated debt pay about the same rate, a risk averse investor living in the States would likely prefer to buy emerging county debt that is pegged to the dollar. There is less risk that way.
While you can indeed get a nice yield from these instruments – beware. Political and financial changes develop fast overseas. Such changes could have a material impact on the value of your investments. While this is a method people use when they are investing for income, it’s not my favorite option.
4. Junk Bonds
Junk bonds are bonds issued by companies that may not be able to repay the debt. That’s why they are called junk and that’s why they pay such high interest. If they didn’t pay those high rates nobody would invest.
The problem with junk bonds is that there are times when companies go kaput. If that happens to a company you’ve bought bonds in, say goodbye to your money. Also, if interest rates rise, the value of the bond may drop.
To make matters worse, if we (or Europe) were to go into a recession, those junk bonds might get clobbered too. That’s because the junk bond issuer’s ability to pay that interest and principal is a function of how well its business in doing. If we drop into a recession, business could turn bad. If that happens, the company may go south – along with your money.
5. Real Estate
While I am not a fan of REITs, I am a fan of real estate. I am talking about direct ownership – not through a fund. With interest rates and property values low, making an investment in rental property could be a great way to get solid income.
But if you go this route you should own real estate yourself or with one other party – max. And as I’ve mentioned before, not every location works. Some markets are still too high – like California. But for other parts of the country, real estate investing could be a wonderful way to capture a nice income check and experience some healthy appreciation down the road.
What are you doing to combat low interest rates and finding higher returns? Do you change your strategy when the economy is poor?