Readers' questions: Generating more income

As interest rates around the globe have been cut, investors who rely on fixed income have been scrambling to try and find solutions.

By AARON KATSMAN
moneythumb (photo credit: )
moneythumb
(photo credit: )
Dear Mr. Katsman, In a recent column you discussed how bonds can be used to help lower volatility in a portfolio. I have a question regarding using bonds for income. I am retired and have a portfolio made up of government bonds to generate income from which I used to be able to make ends meet. As some of my older bonds have matured recently, I am forced to reinvest at much lower current interest rates. As such, I am having problems generating enough income to live off of. Do you have any suggestions? - Bernie, Tel Aviv Dear Bernie, Your situation is actually very common. As interest rates around the globe have been cut, investors who rely on fixed income have been scrambling to try and find solutions to generate enough income to live off of. Needless to say, with interest rates at record-low levels, this has been a near impossible task. You mention that you invest in US government bonds exclusively. Well, the yield on a three-year US government bond is approximately 1.25 percent. Assuming you have a normal standard of living, you will need a portfolio of over $5 million to both protect your principal and generate enough income to live from. For most of us, however, a $5m. portfolio is the stuff of dreams. For investors able to risk a certain amount of principal, I'd like to highlight three ways to generate higher income as part of a well-diversified fixed-income portfolio. CDs (certificates of deposit) For investors who insist on a government guarantee, FDIC-insured CDs are worth a look. A three-year CD comparable in safety to the US government bond mentioned above will yield approximately 2.35%. That's more than a full percentage point higher than the government bond and it still provides FDIC insurance of your investment. Corporate and high-yield bonds Corporate bonds are essentially loans issued by a corporation and are not insured by the government. When a person buys a corporate bond, he is loaning money to the issuer. In return, the bondholder receives his money back when the bond matures (the agreed-upon date for the issuer to repay the principal) and receives interest payments usually paid semiannually. Corporate bonds are rated according to their ability to make interest payments and likelihood of returning principal. Corporations that have solid financial footing are given ratings that are considered investment grade, meaning that their risk of default is low. These types of bonds pay slightly higher rates than government bonds or CDs. A three-year investment-grade bond currently yields approximately 3.25%. This is 2% higher than the US government bond. Bonds that are less stable and have higher default risks are called high-yield bonds. While these bonds carry an increased risk of default, their yields are substantially higher than the other bonds and CDs mentioned. Current yields on high-yield bonds are in the 7%-8% range. Preferred stock Preferred stock is a mix between regular common stock and a bond. Each share of preferred stock is normally paid a fixed, relatively high dividend and has priority over the common stock of a company's assets in the event of bankruptcy. In exchange for the higher income and safety, preferred shareholders miss out on large potential capital gains. To understand how preferred stocks work, let's look at an example. Company X issues a preferred stock at $25, with a coupon of 6%, meaning that every year the investor receives 6% on the amount he has invested, usually paid quarterly. Preferred stocks are considered to be like long-term bonds in the way they trade, meaning that they can be volatile depending on the direction of interest rates and the financial situation of the issuer. This means that the same preferred stock that started at $25 can end up trading much lower, which is, in fact, a common situation these days. Financial institutions are far and away the largest issuers of preferred stock. As the banks have sustained mounting losses due to the sub-prime mortgage affair, preferred stock that two years ago sold for $25, is now trading in the mid-teens to low 20s. To investors who bought the stock at $25, this would mean their principal has dropped. Keep in mind that this loss is only on paper, and investors who need monthly or quarterly income will still receive their annual 6%. It's important to realize that if the company is in financial trouble, they can discontinue paying the dividend. This would mean that your investment would generate no income and your principal would drop as well. Speak to your financial adviser to see how these assets can be used to help you generate more income. aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser, both in the United States and Israel, and helps people who open investment accounts in the US.