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INCOME
The Path to Higher Yields
by Jeffrey R. Kosnett Starved for cash from your investments? Here's the good news: The Federal Reserve Board has begun lifting short-term interest rates from rock-bottom levels, and market forces are pushing up yields on longer-term bonds. But there's also some bad news: Rising rates force down the value of bonds and competing investments, so as you strive for more income, you must tread carefully. Yields from supersafe stuff still have a long way to go before you'll find them appealing. Even with the Fed's one-quarter-percentage-point rate hike on June 30 (its first increase since 2000), yields on risk-free money-market funds and savings accounts remain puny, and will be for some time. Money-fund yields, for example, are unlikely to crack 2% before 2005. A couple of banks, though, will pay 4.8% on certificates of deposit if you're willing to lock up your money for five years.
For better deals, you'll have to look elsewhere. So join us on a trip through the world of high yields. Our recommendations range from quite safe to a tad risky. But everything you see here should hold up reasonably well even if interest rates rise a percentage point or two -- as long as the boosts are gradual and the economy continues to hum. And all of these investments are liquid so that you can get at your money easily.
Win when rates rise
You know about adjustable-rate mortgages. Well, banks also make variable-rate loans to business clients, and when interest rates head up, it's much better to be a lender than a borrower. You can take advantage of rising rates with a mutual fund that invests in variable-rate loans. Yields in this category are the lowest on our tour, but these vehicles are among the safest income producers to own when the Fed is lifting rates.
The only no-load fund in this class is Fidelity Floating Rate High Income (symbol FFRHX; 800-343-3548). It invests in slices of bank loans made to small and midsize businesses. Borrowers usually pay two to four percentage points above LIBOR, a benchmark short-term interest rate used around the world. The three-month LIBOR rate recently stood at 1.6%, and the fund yielded 2.8% after expenses. But as LIBOR increases, borrowers will pay more, and the fund's yield should rise accordingly. As for the risk of borrowers defaulting, Moody's Investors Service says that three-fourths of bank loans are rated single B or Ba. That puts them in the middle echelons of the junk-bond class. But these loans are "senior secured" debt. If a borrower gets into trouble, the banks get dibs before bondholders.
The Fidelity fund returned a bit more than 6% last year and gained just less than 2% in the first six months of 2004 (these figures include appreciation as well as income). It hasn't had a month of negative total returns since October 2002, its first full month of existence.
Utilize utilities
The list of gas and electricity suppliers that flopped while trying to reinvent themselves as growth companies is depressingly long. Many ended up chopping their dividends or dropping them altogether. Those that stuck to their knitting, such as Southern Co. and FPL Group, stood out so sharply that their shares soared, pushing their yields down. Fortunately, the utility industry is so vast that you can find plenty of high-yielding, reliable dividend payers.
Favorable tax treatment makes dividend-paying stocks especially appealing nowadays. Most recipients of qualified dividends pay federal taxes at the rate of 15% (taxpayers in the 15% and 10% brackets pay at the 5% rate).
Even dividends paid by some foreign companies qualify for the low tax rates. An attractive foreign utility that does qualify is Britain's United Utilities (UU; recent price $19), which delivers water and power in northwestern England. Despite the stock's plush 8.5% yield, this is not a company in distress. United says that over the next five years it will raise its dividend in line with British inflation (which is running about 2% a year).
Domestic utilities to consider include Empire District Electric and Great Plains Energy. Empire (EDE; $20), which supplies power in Missouri and three nearby states, yields 6.4%. Great Plains (GXP; $30), owner of Kansas City Power & Light, pays 5.5%. Utilities that sell natural gas as well as electricity provide a bit more opportunity for growth because gas is growing in popularity. Barry Abramson, a portfolio manager for the Gabelli funds, cites Energy East, a gas-and-electric utility in New York and New England, as a candidate for regular dividend boosts of 3% to 4% a year. The stock (EAS; $24) yields 4.3%. An alternative is KeySpan, also in the Northeast. Keyspan (KSE; $37) yields 4.9%. It is selling most of its exploration unit and could use some of the proceeds to boost its dividend.
Tap the energy spigot
Oil prices may not hold at $40 a barrel, but chances are good we'll never see $20 again. And even $30 seems increasingly iffy. As we noted in July (see "Trends That You Can Bank On"), an imbalance between supply and demand almost guarantees that the price of oil will stay high for years to come. The same goes for natural gas.
You can cash in on high prices by buying royalty trusts. Trusts, which trade like stocks, must pay out virtually all of their income after expenses. The distributions, paid monthly or quarterly, tend to fluctuate based on the volume and price of oil or gas sold.
Because of price appreciation, yields aren't as lucrative as they were a year ago. Still, the shares of such trusts as San Juan Basin (SJT; $25) and Enerplus Resources (ERF; $29) yield 9.2% and 10.9%, respectively. Russ Lucas, an independent money manager who specializes in income-oriented energy investments, notes that some trusts haven't raised dividends much or at all, choosing instead to spend part of their price windfalls on additional oil and gas leases or reserves.
And what if energy prices crash? Lucas says the typical oil-trust dividend is secure if prices stay above $32 a barrel. Although a plunge in oil prices would put pressure on share prices, the high dividends should help support the stocks. Natural gas, which fetches about $6 per million Btu's, is in such tight supply that a significant drop is unlikely. So Lucas still likes San Juan, which produces gas, as well as Hugoton (HGT; $23), another gas trust, which yields 7.5%. Canadian Oil Sands Trust (COSW; $35) is a more adventuresome pick. The stock yields 4.5%, but the trust could boost oil production sharply (and raise dividends) if oil prices remain up for several years.
Buy midgrade bonds
Automakers are known for enticing shoppers with rebates and superlow financing terms. Ford and General Motors issue so many bonds, primarily to finance their credit operations, that they essentially have to pay bonus yields to lure investors. "It's called the frequent- issuer premium," says Kevin Akioka, a bond manager with Payden & Rygel funds. Although Standard & Poor's assigns GM a rating of BBB and Ford a rating of BBB- (just above junk status), the yields on some of their bonds are what you'd expect from a junk-rated company. Recently, for example, a Ford bond due in 2031 with coupon of 7.5% (meaning the bond pays $75 per year for each $1,000 of face value) was priced to yield 7.6% to maturity. A GM due in 2033 with an 8.4% coupon yielded 8.0% to maturity.
You should diversify when buying individual corporate IOUs. Hal Goldstein, senior vice-president of J.B. Hanauer, a bond brokerage that caters to individuals, likes an Amerada Hess bond due in 2033 with a coupon of 7.1% and a yield to maturity of 7.2%. He also recommends a bond from May, a department-store company, that matures in 2030 and carries a coupon of 7.9%. It yields 7% to maturity. Hess is rated BBB- and May BBB+, but Goldstein says Hess, an oil refiner and gasoline seller, "is a better company than the ratings indicate." Neither bond is redeemable before maturity.
Reach for real estate
Real estate investment trusts have rebounded from their April shellacking, when the group sank 15% on average. The group certainly isn't cheap. But with the average property-owning REIT yielding 5.6%, up from less than 5% in March, REITs, on the whole, are no longer dangerously expensive.
Given an economy that is growing smartly, REITs that specialize in office buildings and industrial properties make sense. Demand for these kinds of properties should prop up rents, enabling their owners to maintain, and perhaps increase, their dividends. These REITs also offer potential for appreciation. First Industrial Realty Trust (FR; $37) owns warehouses and light-manufacturing plants located in 25 metropolitan areas. Its shares yield 7.3%. In offices, the most attractive markets are the New York City and Washington, D.C., metropolitan areas, Florida and Southern California. REITs with properties in those markets include Mack-Cali Realty (CLI; $41), which yields 6.1%, and Vornado Realty (VNO; $58), which yields 4.8%. Vornado, with properties in New York and New Jersey, regularly raises its dividend and occasionally makes unscheduled capital-gains distributions.
Now, about the tax treatment of REIT dividends: The majority of REIT dividends are taxed as ordinary income, although the portion that comes from selling property is taxed at lower, capital-gains rates. So a 6% yield from a utility -- dividends of which are taxed by Uncle Sam at a maximum of 15% -- is generally more valuable to those investing outside of retirement accounts than a 6% yield from a REIT. Then again, real estate is a growth business, whereas utilities are regulated and are generally slow growers. It wouldn't hurt to own some of both.
Link up with a lender
One of the more unusual yield plays can be found in a company called Allied Capital. Allied (ALD; $24) lends money to all kinds of businesses, both publicly traded and privately held. It also buys and sells parts of small companies and finances real estate. Allied is technically an investment company, so it is required to pay out almost all its earnings. The annual distribution, which Allied has raised each year since 1994, is $2.28 a share -- about half of which is capital gains and half dividends. As with REITs, the capital-gains portion is taxed at favorable capital-gains rates. But the dividend portion is taxed as ordinary income because Allied isn't taxed like a regular corporation.
Allied yields 9.8%. A superhigh yield often signals danger. Indeed, Allied Capital's shares sank 10% on June 24 after the company disclosed that it is the target of an informal inquiry by the Securities and Exchange Commission concerning the way the company values loans. Allied denies any improprieties. John Fox, co-manager of FAM Value fund, says he's comfortable with Allied's accounting and is certain that it will at least maintain its dividend through 2005. Allied executives include "some of the best financial people I know," says Fox.
Enjoy a junk fund
After delivering stellar returns in 2003, junk bonds are struggling this year. Funds that invest in high-yield bonds (issued by companies rated BB or lower by Standard & Poor's) returned 24%, on average, last year. In the first half of 2004, they broke even, which means that for most junk funds price declines offset generous yields.
As a result, junk bonds are more attractively priced than they were six months ago. The spread between Treasury-bond and junk-bond yields, which pros watch to gauge value in the high-yield market, is about 4.5 percentage points. The bigger the gap, the less you pay for junk bonds. At the end of 2003, the spread was just three points.
Indeed, a modest junk-bond rally may be coming. Jeff Ebert, a bond manager at U.S. Bancorp, notes that rating agencies recently upgraded their views on a number of BB-ranked companies. Raters are poised to upgrade many other similarly ranked firms.
For safety's sake, it's best to invest in junk funds that concentrate on the higher end of the quality spectrum. A solid choice among no-load funds is Northeast Investors Trust (NTHEX; 800-225-6704), which recently had about two-thirds of its assets in bonds rated BB and B. The fund, which returned an annualized 3% over the past five years to July 1, yields 8.3%. Others to consider are Vanguard High-Yield (VWEHX; 800-635-1511), which returned an annualized 5% over the past five years and sports a current yield of 7.5%, and Pimco High Yield D (PHYDX; 800-426-0107), which returned 5% over five years and yields 6.9% (Pimco Class D shares are available without sales charges from some discount brokerages).
Collect a closed end
Closed-end mutual funds issue a fixed number of shares and then trade like stocks. A few of these funds are dedicated to big dividends. The catch is that many "leverage" -- that is, they borrow at low short-term rates to buy higher-yielding, longer-term securities. If the Fed hikes rates relentlessly, it will sting because leveraged funds will have to make bigger interest payments, cutting into earnings and leaving less for dividends.
Then again, it could be that the prices of some of these leveraged closed ends already reflect investors' expectations of higher rates. And you may be able to buy one of these funds at a discounted price (unlike their newer cousins, exchange-traded funds, regular closed-end funds usually trade at discounts or premiums to the value of the funds' underlying assets).
Consider John Hancock Patriot Global Dividend (PGD; $12), which invests in utility and preferred stocks and recently yielded 8.3%. The fund traded at a 6% discount to its net asset value per share, meaning that you would pay 94 cents for every $1 worth of securities held by the fund. As late as April, the fund sold above its NAV.
A nonleveraged closed-end fund that sells at a discount is Aberdeen Asia-Pacific Income (FAX; $6). The fund, which owns bonds issued in Australia and Asia, yields 7% and recently traded at a 3% discount to its NAV. It has historically delivered good returns when Asian and Australian economies and currencies perform well, as is currently the case. --Research: Katy Marquardt
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