Income Investing in a Low-Yield World

Zacks

Investors in search of a decent yield on their money have it awfully rough these days. For over three years now, the Federal Reserve has held its key interest rate between 0% and 0.25%.

And with the Fed recently reaffirming its pledge to keep interest rates low until at least late 2014, short-term rates like savings accounts and money market funds will continue paying paltry returns for quite some time. Expect the long end of the yield curve to remain compressed too.

To gain perspective on just how low interest rates are, take a look at today's 10-year Treasury note compared with its 50-year average:

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10-Year Treasury Note

10-Year Treasury Note: Historical Perspective

So what is an income investor to do in this low-yield world? Consider these alternatives.

Blue Chip Stocks

'But stocks are too risky' you might say. In the short-term, yes. But if you pay a reasonable price for a solid business whose earnings are highly likely to be materially higher 5, 10 or 20 years from now, your returns have a good chance of being higher over the long-run than with bonds.

And speaking of risk, don't you consider it risky to lend money to an entity with over $115000000000000 (not a typo) in unfunded liabilities and over $1000000000000 in annual deficits for the foreseeable future?

What kind of rate would you require on your investment? Would you lend that institution your money for 10-years at a measly 2.0%? That return likely won't even keep up with inflation.

Conversely, the earnings yield on the S&P 500 is currently 7.7 based on a forward price to earnings ratio of 13.0. Granted, returns over the last 10 years have not been great for most stocks, even for many blue chips, but much of the reason is that 10 years ago, those stocks were wildly overpriced. That doesn't seem to be the case today.

Moreover, the average dividend yield of the 30 Dow Jones Industrial Average components is a solid 2.8%. And there are several blue-chip stocks with strong cash flows, stable businesses and excellent credit ratings. Also, these companies often raise their dividends annually, unlike bonds which typically pay a fixed coupon.

Preferred Stocks

If you're still leery of investing in stocks, there is a way to get the best of both worlds: preferred shares. Preferred shares are hybrid securities that act like bonds in that investors get a fixed payment, but still represent ownership in a business like a stock (although they typically don't get voting rights). Moreover, some preferred shares are convertible to common stock if a company's share price takes off, providing unlimited upside potential.

The dividends on preferred shares take priority over their common stock cousins, but interest payments on debt take the first priority. Nonetheless, if you're willing to shoulder a little bit more risk, preferred shares can offer attractive total returns.

Foreign Bonds

If you're willing to invest overseas, yields on some foreign bonds, like Brazil and Australia, are very attractive right now. And countries like Canada have much better balance sheets than the U.S. (and AAA credit ratings from Standard & Poors).

MLPs, REITs, BDCs

There's nothing like the threat of taxes on a business to get them to shell out cash to their owners. Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs) all have to pay out at least 90% of their earnings to unitholders in the form of distributions to avoid paying taxes on that money. This way that money avoids double-taxation, which can lead to some juicy yields.

Many of these entities are in highly volatile industries, however, so their distributions often get cut during recessions. But not all of them do. In fact, many MLPs, REITs and BDCs actually raised their distributions during the Great Recession.

Diversify

For income investors, I recommend a mixture of these different income-generating investments. Here are 4 specific ideas within each category above:

Blue Chip Stock Recommendation:
Chevron (CVX)
Dividend Yield: 3.3%
Earnings Yield: 12.7%

This oil giant recently announced its third dividend increase in the last year and has raised it at a compound annual rate of 8% since 1996.

The company generated nearly $15 billion in free cash flow in 2011 and paid over $6 billion to shareholders in the form of dividends, so it looks like it has room for additional hikes down the road.

Seems a lot more attractive than Treasuries to me.

Preferred Stock Recommendation:
PowerShares Preferred Stock ETF (PGX)
Dividend Yield: 6.5%

PGX is an ETF that tracks the BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index which is designed to reflect the total return performance of the U.S. dollar-denominated preferred securities market. Additionally, that yield is the composite of 123 holdings, so investors get the benefit of diversification.

Foreign Bond Recommendation:
PIMCO Australia Bond Index Fund ETF (AUD)
Yield: 6.5% (average as of March 31, 2012)

The Australia Bond Index Fund aims to provide exposure to the Australian dollar-denominated, investment grade bond market.

Australia is a land rich in natural resources, but it is much more than just a mining and agriculture economy. The services sector actually accounts for nearly 75% of GDP, including a very stable financial services industry.

The country of 22 million people has experienced 21 consecutive years of economic growth, even in spite of the global financial crisis.

Bond yields are high because the Reserve Bank of Australia currently has its cash rate set at 3.75%. And unlike the U.S., Australia has a AAA credit rating from Standard & Poor's.

MLP Recommendation:
Holly Energy Partners LP (HEP)
Distribution Yield: 6.0%

Holly Energy Partners is a master limited partnership (MLP) that operates petroleum product and crude oil pipelines, storage tanks, distribution terminals, and loading rack facilities. It is headquartered in Dallas, Texas and has a market cap of $1.6 billion.

The partnership has consistently paid, and raised, its distribution every quarter since going public in 2004. That marks a remarkable 30 consecutive quarterly increases, even during the Great Recession.

The Bottom Line

With interest rates expected to stay depressed for quite some time, income investors need to explore other options. If you're willing to stomach a little more risk over the short-run, these 4 investments offer very attractive returns.

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research.

PIMCO-AUS BIF (AUD): Free Stock Analysis Report

HOLLY EGY PTNRS (HEP): Free Stock Analysis Report

PWRSH-PFD PORT (PGX): Free Stock Analysis Report

CHEVRON CORP (CVX): Free Stock Analysis Report

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