“Cash is king” is an old expression that implies that this most straightforward form of money has the most significant merit for investments. Liquid assets are desirable for their ability to be easily be converted into cash in times of financial stress.
When the stock market tanked in March 2020 due to the pandemic impact on our economy, those with cash on the sidelines were able to grab stocks at battered prices and benefit substantially. Participating in the market has been a challenging year unless you were holding a growth portfolio. Finding income from low-risk investments has been somewhat limited since the Great Recession and has become more so this year.
The Role of The Fed
The Fed, through its monetary policy, took swift action to deal with the economic downturn. They brought down the fed funds rate to nearly zero and expanded our money supply through aggressive quantitative easing measures. These necessary actions caused market interest rates, already low since the Great Recession, to their lowest levels historically. We have commented on the Fed’s role in our economy and its impact on the markets here.
If you are an income investor, the low yield environment has been frustrating to earn returns. Retirees, and those who are risk-averse, often favor income investing. However, income investing is for anyone who wants to balance the risk in their portfolio.
Income generation will likely be a key priority for many people. According to experts, income investors are confronted with low-interest rates today, limiting their returns. So what are their choices? They can be patient or consider adding some risk to the portfolio, which will add better returns. I have faced a similar dilemma, concerned about having too much risk while reaching for yield.
What Is Income Investing?
There are several investment strategies, such as growth, value, and income investing or a combination to give you a more balanced portfolio. We wrote about growth vs. stock investing here. Income investing centers on building a portfolio of investments that are structured to generate income in predictable streams.
The income comes from interest payments earned from having cash in a high yield savings account, interest from bond yields, and stocks’ dividends. Income investors seek low risk, low volatility, stability in their investments that generate income to replace earnings after retirement. An income investing-oriented portfolio may be too conservative to build a retirement fund for someone in their 20s or 30s who have longer time horizons and better tolerate risk.
A more balanced portfolio can combine investments that provide more growth combined with less risky investments. Such a portfolio could be a mix of money markets, Treasury securities, municipal, and high-grade corporate bonds. To add more risk, stocks with good track records for paying good dividend rates can be part of this balanced approach.
Macro Background On Interest Rates And Inflation
Interest rates, the amount charged by a lender to a borrower, are keyed off the Fed’s fed funds target set as one of its primary policy tools. When the economy is weak, the Fed reduces the fed funds rate to stimulate the economy, influencing other borrowing rates. Consumers, if incented with a lower mortgage or car loan rate, spend and borrow money. Related post:
As the economy recovers and strengths, it may cause inflation to rise. If inflation is too high, the Fed will raise the fed funds rate to cool off the economy. Inflation is when there is a general and steady increase in the prices of a basket of goods and services. Inflation reduces your future purchasing power compared to the money you have today. We have been experiencing low inflation, below the Fed’s target of 2%.
How Interest Rates And Inflation Impact The Markets
Interest rates and inflation rates can have a significant impact on stocks, bonds, and other investments. When interest rates fall, the interest payments received from bank deposits decline. The low-interest rates will cause lower yields from income-generating investments like CDs, other money market securities, and bonds. Income investors rely on these investments for predictable income streams and to preserve their capital, but higher yields are hard to find unless you add risk. There are different strategies for an investor to add more income by balancing risk and diversification.
The low-interest-rate environment should remain for the foreseeable future. What about inflation? Low-interest rates, if they do their job in stimulating the economy, can lead to higher inflation. If there has been a concern, it has been about zero inflation or deflation. Deflation is problematic because it means reduced pricing in goods and services. Lower prices could lead to reduced wages, lower production hurting our economy.
Trade-Off Between Risks And Returns
All investors need to consider the risks and returns for their investment choices. Typically, risks and returns are positively correlated. Moving in the same direction means that making low-risk investments is usually commensurate with low returns while taking high risks should be compensated with high returns.
Wouldn’t we all seek low-risk investments to be rewarded by high returns? Madoff’s high return strategy turned out to be a spectacular Ponzi scheme.
Low-Risk High-Return Strategies
I can point to a few legal low-risk high return strategies if you look for income generation from money in savings. Here are a few possibilities that may be beneficial for your pocket:
Refinancing your mortgage may produce savings, net of fees if you are currently paying a higher mortgage.
Paying off high-cost credit card debt will provide positive returns if you are being charged double-digit rates and carrying balances.
Reduce or eliminate other consumer loans if you can refinance loans at lower rates.
Improving your credit scores ahead of planned borrowing may produce some savings.
Lifelong learners can seek out learning new skills or training that can bump their salary.
Various Risks To Consider When Investing
Before anyone becomes an investor, you should understand that all investments carry risks. There are no free rides, but you can protect yourself from the downside of losing hard-earned money. While you may not be able to control all the risks, there are ways that you can protect yourself from them. The ability to take on risk varies by individuals based on age, income, net worth, lifestyle, time horizon, family responsibilities, and tolerance.
Here Are Some Of The Potential Risks:
Interest Rate Risk
Interest rate risk is a risk that occurs when interest rates rise, causing bond prices to fall. Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.
All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer bonds have higher yields.
Inflation risk, also called purchasing power risk, is the danger that your money will not keep pace with inflation. As such, your money will be worthless in the future than today. When investing for the long term, be aware that inflation may diminish your returns. Deflation risk has the opposite effect. The value of an investment will decline in the face of lower overall prices.
Putting financial resources into a bank savings account does not generate much income when interest rates are low. Putting money in a low yielding bank account is saving, not investing. As such, you incur opportunity risk from not pursuing higher growth options.
Credit or default risk is the uncertainty associated with not receiving promised periodic interest payments and the principal amount at the time of maturity from the bond issuer.
You cannot easily convert some assets into cash without losing value, which is liquidity risk. An asset quickly convertible into cash with minimal loss is liquid. Treasury securities are notable for having strong liquidity characteristics. However, other investments such as real estate or collectibles have greater liquidity risk.
Time or duration risk refers to assets like debt securities that mature at different times. Typically, the longer the term to maturity, all other things being equal, the greater the risk. For example, a two year Treasury note should provide a lower return than a 30 year Treasury bond.
Market volatility risk varies between securities and even within an asset class. Typically, high growth tech stocks are likely to be more volatile than a utility stock.
Reinvestment risk is the risk that the return on a future investment may not be the same as the return currently found on the same asset. If you rolled over a CD this year that you owned in 2019, chances are you would be doing it at lower returns.
Where To Find Yield In A Low-Environment
Seeking income in the current environment is a matter of considering your risk-reward profile when putting together an investment portfolio. Sitting down with a financial advisor can be hugely beneficial. They likely have years of experience and talk to many investors facing the same predicament as you.
To help your understanding of the possible investments available and the relative risk, from the low to high risk, here are choices:
High Yield Saving Account
Keeping your money in a traditional savings account will not provide you much interest based on an annual percentage yield (APY). However, it is a better alternative to keeping your money in your checking account. That is just a recipe for spending more.
High yield savings accounts are preferred over traditional savings accounts as they are known for rewarding with higher yields. Bank accounts are FDIC-insured up to $250,000 per account, so there is no risk. Restrictions like monthly fees, minimum balance requirements, and withdrawals offset offers of higher yields. During the pandemic, banks may have relaxed limits. Shop around as there is plenty of competition where you can get 0.80-1.00% APY.
Certificate of Deposits or CDs
A CD is an interest-bearing saving instrument purchased for a fixed period from three months to eight years. Minimum deposits may range from small amounts up to $100,000. CDs are FDIC insured, like bank accounts. CDs have slightly higher yields than high yielding bank accounts. For the best rates, check Bankrate for their best and latest rates.
The longer the period, the higher the rate on the CD. You probably don’t want to subject yourself to a more extended period if you expect higher inflation in the future.
Banks often have minimums of $1,000 with fixed rates are fixed through expiration. If you withdraw your money, you will likely pay a penalty charge. There are variable CDs where rates fluctuate.
Money Market Securities
Money market securities are a mix of short-term debt securities and are also known as cash-equivalents. Like high yield bank accounts, they are liquid as they can be quickly convertible into cash with little or no loss of value. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These money markets generally mature in one year or less and trade in the secondary market.
Money market securities differ by the issuer. The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.
MMDAs And Money Market Funds
Money market deposit accounts (MMDAs) are government-insured from a depository institution. They vary on the size of account balance, the number of transactions each month, minimum deposits to open and maintain. Alternatively, investment advisers offer money market mutual funds. Money market funds are uninsured like the MMDA, but they may be more flexible in their terms.
Keep in mind, the income from money market securities is historically low. For example, a six month T-bill currently yields just 0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free that short-term T-bills have been traditionally more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range.
Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly great for your emergency fund.
In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, especially when interest rates rise.
Government Savings Bonds
Series EE and Series I government savings bonds are promissory notes issued and backed by the US Treasury. Income generated is exempt from state and local income taxes. These are low-risk investments with low rates. The Series is available online through Treasury Direct. They can be bought at denominations as little as $25 and often are as gifts. Series EE provides a market-based fixed interest rate, and Series I adjusts for inflation.
Savings bonds have a 30-year maturity and can be redeemed any time after 12 months (if issued after February 2003). However, holders will lose the last three months of interest. Investors can report the accumulated interest or defer until maturity.
Bonds of Varying Risk And Return
Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon). The issuer pays the principal on maturity.
To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate, paid semiannually.
Bonds provide predictable fixed income streams. Bonds vary in credit risk from the Treasury securities rated AAA to municipal and investment-grade corporate bonds rated BBB or better. There are also corporate bonds that provide higher yields than investment-grade corporate bonds. The high yield bonds are often called “junk bonds” because of their more risky nature.
When you invest in a bond, you are effectively lending money to the issuer instead of owning part of a company’s equity when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors.
Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.
All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issue bonds are at higher yields.
Treasury Bonds Are Safe and High Quality
In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities. Like money markets, Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.
Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,
Historically, T-bonds returned 5.5% per year, but today it yields about 1.67%. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is that they are subject to interest rate and inflation risk. To counter inflation risk, TIPs or Treasury Inflation-Protected securities adjust rates with the inflation-indexed CPI. Variable bonds that adjust inflation rates are also available in most fixed securities, particularly munis and corporate bonds.
Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation. Without inflation protection, a bondholder with a 4% interest rate is fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.
Municipal Bonds Have A Unique Tax Benefit
State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households. Muni yields at 1.52% on a 30 year AAA bond is close to the 30 year T- Bonds. Municipal bonds have better tax benefits than Treasuries.
Tax Exemption A Big Plus
Owning a municipal bond has outstanding tax benefits. Muni holders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the returns of riskier corporate bonds.
These securities are attractive, especially if your marginal tax rate is above 25%.
While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with diverse muni securities.
Corporate Bonds: High Grade Or High Yield
Corporations issue debt instruments vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.36% versus 3.02% a year ago.
Disappearing AAA Corporate Bonds
There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with merger & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the Great Recession.
High Yield Corporate Bonds
For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Being diversified is your best path to exposure to these risky instruments.
The riskier, higher-yield “junk” bonds have higher yields than high-grade corporate bonds. Historically, junk bond yields are 3%-7% higher yields than investment-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Typically, debt-heavy companies that are restructuring issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds currently in the 3%-4% range, but; remember these bonds carry higher risk.
Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock. As creditors, these bondholders have priority claims in the event of a default, which stockholders do not have.
Preferred stock is considered equity but shares characteristics with bonds and common stock. This security is a type of fixed income ownership security in a corporation. Like a bond, preferred stock may have call provisions and rarely provide voting privileges held by stockholders. Preferred stockholders receive fixed dividends per share and have priority claims after bondholders but before common stockholders receive dividends. The market price of preferred stock is sensitive to interest rates, like bonds.
The attraction to income investors is the regular dividend payments. Investors can rely on dividends. Sometimes companies skip payments, due to poor results, for example, but are eventually paid to the holders of cumulative preferred stock provisions. Preferred stockholders have priority claim over the common stockholders. The preferred stock carries a higher risk than traditional high-grade corporate bonds but less so high yield bonds or growth stocks. For income investors, preferred stock may be a good alternative.
Not every corporation issue preferred stock. Specific industries are known to issue preferred stock, such as financial institutions, telecom, energy, and utility companies. You can buy them individually though, for diversification purposes, buying ETFs like iShares US Preferred Stock ( 4.93% yield) or Invesco Preferred (5.49% yield) may be more desirable.
Common Stocks With Strong Dividend Track Records
With the highest historical S& P 500 annual returns of 9-10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. However, they are too risky for most income investors.
This group of stocks is classified as income stocks (instead of growth stocks) because they tend to grow less quickly but are relied on for above-average dividends consistently paid. These stocks tend to be less volatile because of the higher dividend yield, which provides an anchor.
Companies or stock groups with above-average dividend yields are ATT, Verizon, Kraft Heinz, energy stocks, utility stocks, and REITs. Dividends from REITs, or Real Estate Investment Trusts, are substantial because they are required to distribute at least 90% of their taxable income to their shareholders annually. The average dividend yield for equity yields is above 4%, making REITs an attractive investment.
They are presumed to be safer, defensive, and slower-growing companies. One concern is whether that high yield is vulnerable to a cut in its dividend. Look for high-quality companies that have a history of paying above-average dividends.
Blue-chip stocks that pay dividends may be an excellent place to go for companies that have been around a long time and have track records. Not all blue-chip stocks pay dividends.
Income investors may want to look at Dividend Aristocrat stocks. These stocks are an elite group of companies in the S&P 500 that paid and raised its dividend every year for at least 25 consecutive years. There are more than 60 companies on this list in 2020.
This subsector of above-average dividend-paying stocks is attractive for income investors. Coca Cola, Johnson & Johnson, Dover, Chevron 3M are in this elite group for more than 50 years.
Income investing is known for its predictable income streams and preservation of capital. Finding income in a low yield environment may be difficult these days. Adding some risk to a basket of government and corporate securities and income-oriented may be a good strategy. Remember to remain diversified in your assets.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.