Article I: Income Opportunities For Retirement Capital

Income Opportunities For Retirement Capital
by Sam Dreher
December, 1999

Just six years ago, in 1993, interest rates were at the bottom of their long slide from the early 1980’s. I played golf with an individual who actually had to go back to work part- time because interest rates were so low. He had retired in the early 1980’s and, not wanting to take any risk with his capital, put all his money in one-year Certificates of Deposit. Those CD’s paid 14% interest at the time; by 1993, however, his CD’s were rolling over at 3%, and his income had declined by 78% [(14% – 3%)/14%]. The risk he had forgotten to consider was reinvestment risk.

For many, retirement involves changing from an accumulation stage to an income stage, at least as far as one’s outlook on capital in concerned. What should be, seemingly, a simple transition gets complicated in the asset allocation process. You know the siren song of the investment community: living longer, needing growth, international diversification, emerging market exposure, large-cap, mid-cap, small-cap, blah, blah, blah. The confusion happens when you have $1.0 million, spend $90,000, and earn 11% in growth and income. Did you spend any principal? (Probably depends on how much taxes you paid.) Or, with a large percentage of capital allocated to growth (implying the willingness to assume market volatility), do you spend principal when your account drops 8% and its current yield is only 3.2%?

But that’s another subject. The point is that unlike 1993, when income alternatives were almost non-existent, today’s marketplace provides a variety of attractive income selections. In my opinion, it would behoove investors to give more consideration to income opportunities, even as the financial community is steering them toward more growth investments and inventing ways to guide their capital into high-risk areas of the market. Relative to inflation, for example, U.S. Government and Agency bonds are more attractively priced than anywhere else in the world. They pay between 5% and 6.5%, depending on maturity, and their interest is exempt from state income taxes.

Speaking of income taxes, rates on municipal bonds, which are exempt from Federal income taxes, have soared, creating another opportunity investors should consider. Many closed-end, tax-free bond funds traded on the New York Stock Exchange now yield between 6.5% and 7.0%, plus they are selling at a discount to their net asset values. Granted, they have some duration issues which means their yields will decline gradually as bonds are called before maturity, and many employ leverage to augment current yields, which also could result in lower pay-outs given a dramatic change in the yield curve; but these are the same issues investors were fighting over in the new-issue market a few years ago when they were priced at a 9% premium to NAV’s.

Now these closed-end funds, selling below NAV, are yielding 9.25% to 10% on a taxable- equivalent basis for investors in a 30% income tax bracket. (If you’re wondering why your broker hasn’t recommended any of these funds to you lately, remember that when they were new issues they paid a commission of 3% to distributing sales persons. In today’s world of discount trading, buying these funds on the NYSE, instead of the new-issue market, means even full-service brokerage fees would be 1% or less. The investment community is busy selling investors annuities, unit investment trusts buying everything from income securities to internet stocks, and open-end mutual funds with exit charges so complex they need half the letters of the alphabet to describe how you take your money out. All of these packaged products continue charging investors high commissions.) Doesn’t a simple tax-free 6.75%, equivalent to 9.6% taxable in a 30% tax bracket, deserve some consideration?

One caveat on the tax-exempt’s, however, is their effect on social security taxes. While investors in low tax brackets may be tempted by tax-free yields almost as high as some taxable returns, they need to examine their income tax liability after taking into account the amount of social security that is taxable. It’s a “cruel and unusual” way for the Government to raise money, but the fact is that tax-free income actually increases the amount of social security that is taxable. So if there’s any question about this effect, investors need to consult their accountants before buying tax-free bonds.

Going up the risk scale, corporate bonds are now priced to provide a generous premium over Governments. A diversified portfolio of investment-grade corporate’s–BBB-rated or higher by either Moody’s or Standard & Poor’s–can be assembled directly (no mutual funds) without worrying too much about investment risk; investors only need to select maturities, which is when they want to get their money back. The main caveat in this area is “event risk”. A change of control can result in a high-grade bond becoming junk the next day, so unlike investing in Governments, corporate bond investors need to achieve some diversification.

As far as returns on corporate bonds are concerned, between 1% and 1.5% over Treasury bonds is available. Investors can look for yields ranging between 7% and 8%: not an “Internet-return” of 300%, but rather respectable in the context of an IRA which pays no taxes until the money is distributed.
Preferred stocks, which today are mostly corporate bonds in disguise (so issuing companies can deduct dividends for tax purposes), offer another 1% in yield, or around 9% to 9.5%, assuming the same rating parameters by Moody’s and S&P. In exchange for the higher returns, there are a few disadvantages. In the preferred market, the borrower, not the lender, decides when the lender gets her principal back. If interest rates fall, the borrower may retire the preferred with a call feature, putting investors back in the market for income at an inopportune time when interest rates are lower. And if rates rise, investors will experience a decline in the value of their shares, although their income streams should remain constant.

Most new issues of preferred stock come with five-year call protection, so a drop in interest rates is not necessarily as bad as described above. Plus, many older preferred issues now sell below their call prices, giving investors a chance to experience capital gains if an issue is called. Protection from rising interest rates is not as good. Most preferred’s come without maturities, so buying them in a rising interest rate environment is like buying a company’s most subordinated debt without a maturity: not a place for “all the money”.

The next item on the risk ladder would be corporate and preferred issues rated below investment grade by Moody’s and S&P. My advice on Junk securities is to use them sparingly and only as an asset class via a mutual fund rather than on a direct-investment, individual-issue basis. Unlike securities in the investment grade category, Junk possesses investment risk–meaning the ability to return principal is less than satisfactory. Ordinary investors need the expertise of analysts and the benefit of wide diversification to efficiently capitalize on the extra returns available in this area of the market.
Of course, a discussion of income opportunities would not be complete without considering today’s remarkable current yields on Real Estate Investment Trusts. A few years ago, well-established REIT’s yielded less than long-term Government bonds because, unlike interest on the bonds, which is fixed, the dividends on REIT’s increase, allowing investors to experience rising income streams. Today, many REIT’s yield over 9% on a current basis, and some continue to raise their dividends annually (some even quarterly).

Many reasons can be cited for the market’s demotion of REIT’s into the investment cellar. During the good years, REIT management’s issued new shares aggressively and flooded the market. Dividend increases are expected to decline as the recovery from the depression in real estate a decade ago has about run its course. The demand for some real estate will fall, or disappear altogether, as the Internet eliminates the retailer. Lastly, it’s easy to get higher returns, albeit from growth, in more conventional areas of the market, such as index funds, Internet stocks and IPO’s.

Whether these concerns are real or not, and to what extent they may permanently alter the investment rules for REIT’s, remains to be seen. On the positive side, investors in REIT’s can create an attractive income stream, stemming from a comfortably diversified source. REIT’s are available that specialize in apartments, shopping centers, golf courses, automobile dealerships, office buildings, warehouses, public storage, hospitals, nursing homes, retirement communities, hotels and even prisons. Further diversification can be achieved on a geographic basis. Whatever the dire consequences implied by the market’s present disregard for the group, it’s hard to conceive of all the above real estate categories being vaporized, much less at the same time.

While an economic downturn or the concerns mentioned above could result in some dividend reductions, or a halt in some dividend increases, few REIT’s appear vulnerable enough to lose their property, which is the source of the income. Further, at today’s depressed prices, many REIT’s are attractive takeover candidates; or, as has actually happened in some cases, likely to sell their properties and pay shareholders a handsome premium over recent market prices in a company liquidation. Any catalyst that results in a more normalized pricing structure could provide REIT investors with 25% to 50% capital gains on top of 9% current dividend yields. Thus, while again not a place for all the marbles, REIT’s deserve consideration for a portion of retirement income portfolios.
In review, investors should respect today’s income selections, even as these opportunities in part stem from a lopsided concentration on growth investments. A little downturn in the equity market and an upswing in fixed income securities could make today’s current yields look awfully dear. Typical asset allocation schemes take 10% appreciation for granted: 3% from income, 7% from growth. I suggest that investors give more serious consideration to this formula and its assumptions. While 7%, 8% and 9% are being given away in the income section of today’s investment universe, should retired investors be looking at 5% from income and 5% from growth, or 6% from income and 4% from growth? A mere six years ago there wasn’t a choice.

Selected interest Rates & Dividend Yields(1)

Item Maturity Est Return Characteristics
Governments/Agencies 5-30 Years 5%-6.5% No credit risk, interest exempt from State taxes
Municipals 10-25 Years 5%-7% Low credit risk, interest exempt from Federal taxes
Corporates 5-20 Years 7%-8% Event risk, diversification important
Preferreds See Text 8.5%-9.5% Callable features put lender at a disadvantage
REIT’s See Text 8%-12% Not a debt instrument, gains or losses possible
(1) Approximate as of December, 1999. Individual items not appropriate for all investors. This table for summary purposes only.