Looking for yield? You are certainly not alone. The demand for income-producing assets is growing and will continue to grow in the years ahead as more and more baby boomers leave the full-time workforce and navigate their way through a new chapter in their lives. But the Fed’s ultra-easy monetary policy is complicating things for income-focused investors by helping to hold yields lower than they otherwise would be. So what’s an investor to do?
Despite an historically low interest-rate environment, there are still ways to capture inflation-adjusted, after-tax “real” yields. Four such ways include:
1. Extend maturities – If you are willing to venture away from short-term bonds providing negative real rates of return and purchase intermediate- to long-term bonds, you can increase your yield. As you extend maturities, you will also increase the potential for bigger price swings in your principal. It is for this reason that I think investors extending maturities should mostly do so with individual bonds. Absent widespread defaults, with a diversified portfolio of individual bonds held to maturity, the price swings of today will be irrelevant in the future. If you manage your liquidity in such a way that you can avoid having to ever sell, then price swings can be ignored. Purchasing preferred stocks is another way to essentially extend maturities and capture higher yields. While I think preferred stocks deserve a place in an income-focused investor’s portfolio, I also think the allocation should remain relatively small.
2. Move down the credit quality scale – By moving from fixed income securities considered to have very little risk of default into those considered to have a higher risk of default, investors can also increase yields. This doesn’t necessarily mean moving into “junk” bonds. It could instead simply mean, for example, moving from double-A-rated bonds into triple-B-rated bonds.
3. Look for one-off opportunities in companies or industries that have experienced spread widening – Just as the stock market will offer one-off opportunities for investors, so too does the bond market. If you are not the type of investor who frequently runs bond screens, one way to identify one-off opportunities is to find companies with stocks that have sold off in excess of what would be expected based on the broader market’s performance, and then take a look at those companies’ bonds.
4. Move down the capital structure from bonds into equities – Given the low interest-rate environment of recent years, many investors have turned to dividend-paying equities to capture higher yields. This strategy can provide very nice streams of income, especially if you own dividend-growth stocks and have the wherewithal to hold stocks through thick and thin. If you decide to go this route, remember to calculate the opportunity cost of buying, say, a 3% yielding common stock that you anticipate will grow dividends over time versus, say, buying a 6.50% yielding preferred stock or bond.
There isn’t necessarily a universal best way to go about capturing “real” yields over time. Your investment objectives will help push you in one direction or another. I, for example, happen to use a combination of all four of the methods mentioned above.