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Jubak's Journal
Recent articles:
• In earnings-warning season, excuses count, 7/3/2003
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How to survive the income-investing crisis
Anybody living off earnings from savings, CDs or bonds knows the flip side of low interest rates. Here are 4 strategies for boosting returns.
By Jim Jubak
Were in the early stages of an income-investing crisis.
Low interest rates are great if youre buying a house, refinancing a mortgage or looking to buy now and pay much, much, much later.
Falling interest rates have put some pop back into stock prices this year and rewarded bond owners with total returns (thats interest payment plus price appreciation) of near 5% on 10-year Treasury notes and near 10% on corporate bonds.
And the Federal Reserve is betting that low interest rates are the medicine that will send economic growth rates above 3% and knock unemployment below 6%.
But low rates are a disaster for anyone who actually has to live on the income generated by savings accounts, money market funds, certificates of deposit and bonds. The Federal Reserves June 25 move to drop its federal funds rate to 1% was the 13th cut in short-term interest rates in 2 years. Short-term rates stood at 6.5% when that process began.
A $250,000 portfolio invested just at that minimum interest rate would have earned $16,250 in interest income a year. Today, that same portfolio invested at the Feds target rate would produce just $2,500.
You dont have to go back even that far to see a huge change. A year ago, 10-year Treasury notes were yielding 4.8%. Thats $12,000 in income. At the June 30 yield of 3.5%, that portfolio would produce just $8,750 in income a year. Thats a drop of almost 30% in just 12 months.
Of course, income investors in five-year notes or five-year certificates of deposit have been sheltered from much of this drop. They wont feel the change in yield until one of these long-term investments matures and they have to roll it over. But imagine the potential income drop facing an investor who owns a five-year, 6.5% Treasury note thats about to mature. By locking in current low yields for 10 years instead of five, that investor can get a yield of 3.5% on a 10-year Treasury.
Conservative investors who kept their cash in short-term instruments such as CDs and money market accounts have already felt the pain. A year ago, three-month CDs were paying 1.81%. Now the yield is down to 1.02%. Thats a 44% drop in 12 months.
And with the Fed promising to keep rates low until the economy shows signs of overheating again -- inflation, can you imagine? -- the crisis facing anyone trying to live on the income from a portfolio isnt likely to go away quickly.
OK. Thats a long enough litany of bad news. What should income investors do to get through this crisis?
Let me handicap the pluses and minuses of the four available strategies.
Go longer
That bond investor above whos thinking of buying a 10-year Treasury to replace a five-year note is an example of this potential strategy.
On the plus side: Taking on a longer maturity will raise the income you get from a bond portfolio. The three-month Treasury bill yielded just 0.84% at the end of June, while the 10-year Treasury note yielded 3.51%. So, yes, an investor can lengthen the maturity of a portfolio to increase its yield. And if the Fed manages to appreciably drive down interest rates anywhere in the short term, it will be at the long end of the yield curve. The nimble bond trader might be able to pocket a capital gain.
On the minus side: That investor is lengthening the maturity of that income portfolio at a 45-year low in interest rates. By buying a 10-year bond, youre locking in current low yields for the full 10 years. If rates start to climb, you could, of course, sell the bond, but rising interest rates will drive down the price of bonds. Most significantly, rising rates will drive down the price of long bonds. If you believe, and I do, that rates are going to stay near current levels for at least a year, then going slightly longer by replacing, say, a three-month CD with a six-month CD makes sense. But locking in five- or 10-year maturities at this point is too much of a gamble for most income investors.
Go riskier
You can beat the 3.51% yield on the 10-year Treasury note by buying the 10-year bond of retailer Target (TGT, news, msgs). In exchange for the greater risk that Target will go belly up before the U.S. government does, investors are paid a yield of 4.25% on Targets bond. Take on a bit more risk with the 10-year bonds of J.P. Morgan Chase (JPM, news, msgs) and the yield goes up to 4.45%. Take on even more risk and the yield goes still higher: The new 10-year notes offered by General Motors (GM, news, msgs) yield 7.15%, or about 3.6 percentage points above the yield on the 10-year Treasury.
On the plus side: Taking on more risk will deliver a higher yield. And at the extreme end of the risk spectrum, junk bonds -- bonds that have earned a below-investment-grade rating from one or all of Standard & Poors, Moodys, or Fitchs bond rating services -- will also deliver equity-like returns from capital appreciation. That assumes, of course, that the economy gets better and any of the companies issuing these bonds gets a credit upgrade.
On the minus side: Investors are taking on more risk and not being paid particularly well for it in absolute terms. General Motors' 10-year notes are indeed paying a hefty 3.6 percentage points above Treasury notes. (That difference is whats known as the spread.) But in absolute, rather than comparative terms, GM is still paying just 7.15%. Thats not especially generous for a company with significant cash-flow problems over the next 10 years. And theres a lot of really, really risky paper out there in the bond market, and the supply is getting larger by the hour. The Feds easy-money policy in combination with income investors hunger for higher yields has made it possible for even the shakiest of companies to issue debt. The airline industry, for example, added $29 billion in balance-sheet debt from 1999 to 2002 and now faces debt repayments totaling $21 billion by 2006. But that hasnt stopped the industry from raising new debt by pledging the value of spare parts or issuing bonds that convert to stock. I wouldnt go reaching too far out here. Too much of the highest-yielding new debt being issued now is so complex in its structure and the underlying businesses are so leveraged that the extra yield isnt enough incentive. (The same advice goes for buying junk through a mutual fund: Many funds are pushing further and further out on the risk curve. Stick with conservative management.)
Eat into your capital
Some financial advisers are telling clients to dig modestly into principal to replace lost income rather than take on more risk by potentially locking in low rates for a long period or taking on more risk. Thats tough love: Most investors instinctively shy away from spending capital. But its actually a trade-off between consciously deciding to reduce your capital by spending it and potentially reducing your capital by adding risk.
On the plus side: You know exactly how much of your capital youll spend to make up your income gap. Thats better than risking difficult-to-estimate losses across your entire portfolio as you reach for higher yields. This is an especially attractive option if you think that the yield opportunities and risks will improve significantly over the next year or two. And it can readily be combined with strategies No. 1 and No. 2 so that an investor needs to take less risk by reaching for less yield because some expenditure from capital will make up the difference.
On the minus side: Well, its obvious, isnt it? You eat into your capital.
Look for high-dividend stocks
The massive, decade-long rally in the bond market and 13 Fed rate cuts have reduced the yield gap between bonds and some stocks. For example, at a time when the Standard & Poors 500 yields 1.64% and the 10-year Treasury 3.51%, BP (BP, news, msgs) yields 3.8%, ChevronTexaco (CVX, news, msgs) 3.9%, Rio Tinto (RTP, news, msgs) 3.5%, A. Schulman (SHLM, news, msgs) 3.3%, FPL Group (FPL, news, msgs) 3.6%, and R.R. Donnelly & Sons (DNY, news, msgs) 3.9%. And if you want to stretch on risk to gain yield, among stocks you can try Central Vermont Power (CV, news, msgs) at 4.6% or Cedar Fair (FUN, news, msgs) at 6.04%.
On the plus side: The dividends on stocks such as these will grow over time as management raises the dividend. So your actual cash income from this part of your portfolio isnt fixed. Also many high-dividend stocks offer good protection from interest-rate increases and inflation, since its likely that an economy thats growing fast enough to force interest rates up would be growing fast enough to lead to earnings growth at these companies. Like junk bonds, these stocks combine income with a way to participate in any economic recovery. And I think that in most cases theyre easier for the average individual investor to understand and analyze than most of the recent wave of high-yield offerings in the bond market.
On the minus side: If these stocks have the potential to appreciate with an economic recovery, they also have the potential to fall in price. Many income investors arent comfortable with the kind of volatility that can come with investing in stocks. Going forward, these types of stocks, with their substantial dividends, are likely to be no more volatile than bonds under many scenarios and much less volatile than bonds if interest rates and inflation kick up again in a couple of years. Something to factor into your risk/reward calculations.
So which of these strategies should you use to get your portfolio -- and your life -- through this crisis in income investing?
All of them. In a mix that works for you and your circumstances.
For example, you might go long with part of your portfolio to increase yield by buying one of the guaranteed-principle bonds issued by Bank of America (BAC, news, msgs) and General Motors. These bonds, sold in small lots tailored for individual investors, have long maturities and so pay higher yields. But upon the death of the owner, the bond can be redeemed for its full face value by the owners estate or heirs. Thats protection against the erosion of your estate through higher interest rates or inflation.
Despite that protection, these bonds still lock you into todays lower interest rates, so you might want to mix them with a dose of high-yielding common stock. That gives you some exposure to any economic recovery and lets you participate in future dividend increases.
Retain some flexibility but still increase your overall yield by moving your part of your cash from extremely short-maturity vehicles to something just slightly longer. So from a seven-day money market fund, go to a short-term government fund. Or from a three-month CD to a six-month CD. The Fed has said rates arent headed up soon, and I think its reasonable to take the central bank at its word on this.
Add a dollop of credit risk by buying bonds of a company or two that looks like its got a good chance to improve its balance sheet and perhaps its credit rating. Companies with good fundamentals but substantial debt loads are good candidates. Waste Management (WMI, news, msgs) is an example.
That kind of approach requires a good deal of hard work and maybe even paying for more advice from a financial advisor than youre used to. I dont see a real alternative. I dont think theres a simple way out of this tight spot for income investors. No magic bullet. No solution with the wave of a wand. (Does Harry Potter do financial planning?)
And if the Fed succeeds in bringing down long-term rates, the squeeze could get even worse.
Doing nothing and doing too much of the first thing that comes to mind are both easier. But I think both approaches will cost you money in the long run.
New developments on past columns
The rate cut could hobble Europe and Japan
The bad news just keeps getting worse for the slumping German economy, the large industrial economy most likely to slip into recession, according to the International Monetary Fund. Government figures released on July 4 show that manufacturing orders fell in May for the third time in four months. The decline of 2.2% from Aprils level was far worse than economists had predicted. Export orders were the culprit, falling 4.8% thanks to the climb of the euro versus the U.S. dollar that has made German goods more expensive overseas.
Changes to Jubaks Picks
Sell Seagate Technology
Ive held Seagate Technology (STX, news, msgs) shares as theyve run through my $18 price target because it looked as if the company had a good chance to deliver an upside earnings surprise when it reports on July 15. But with Seagates June 27 announcement that earnings for the quarter would come in at 30 cents to 33 cents a share, well above the 28 cents a share then expected by Wall Street analysts, the reward for waiting is much diminished. Investors are now speculating that the company will beat even its own recently raised guidance. So Im selling Seagate out of Jubaks Picks with a 45% gain since I added the shares on May 13. In other recent news, the group that took the company private and then public again has filed to sell 60 million of its shares. That would reduce its stake in the company to around 60% from the current 74%.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: BP. He does not own short positions in any stock mentioned in this column.
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