Don't Be Fooled by "Safe" Payouts
Nov 23rd 2011 9:52AM
Updated Nov 23rd 2011 9:58AM
With so many investors looking to earn income from their portfolios any way they can, it's no surprise that financial advisors are touting a wide range of investments designed to produce that much-needed income. But the lesson you need to remember is that there's no such thing as a free lunch, and if a yield looks too good to be true, you should dig deeper until you figure out how each investment produces the income it pays.
Those who have already retired are arguably in the worst position right now. Typical financial planning rules tell them that they ought to invest in bonds and other conservative investments to avoid volatility in favor of regular investment income. But those low-risk investments aren't paying enough income these days to let many retirees make ends meet.
As a result, retirees are drawn to any investment that promises better yields than they can get from their local banks. Over the weekend, an article in Barron's focused on exactly those wishes, arguing that investors can earn yields of 7% or more safely.
But when you take a closer look at some of the investments the article suggests, you won't find the risk-free plays the article seems to promise. Let's examine some of these recommendations a bit more thoroughly.
In corporate and municipal bond realms, the article names several funds that pay attractive yields. Although iShares iBoxx High Yield Corporate (ASE: HYG) and the similar SPDR Barclays High Yield Bond (ASE: JNK) are traditional ETFs, many high-yielding bond investments are closed-end funds, which let you pick up shares at a discount to their intrinsic net asset value, making them even more attractive.
But what the article doesn't point out is that many closed-ends often use leverage. That works fine as long as short-term rates stay low, but once they rise, shares can quickly lose value.
In addition, some closed-end funds have managed distribution policies, whereby the payments that they make aren't directly related to the income their investments produce. What often happens is that investors essentially receive their own investment capital back in the form of distributions, reducing net asset value over time. That can be a nightmare over the long run if you're expecting to preserve principal.
Lastly, the idea that corporate and municipal bonds are without risk these days is ludicrous. With municipal bankruptcies in places like Harrisburg, Pennsylvania and Jefferson County, Alabama, default risk exists. And although actual default rates on junk corporate bonds have been quite low, there's no guarantee they'll stay that way.
Like many others before it, the Barron's article plugs mortgage REITs like Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) . With their high yields, the article argues that their only risk stems from interest rate changes -- changes that the Federal Reserve has promised not to make.
But that's far from the only risk that these REITs carry. In order to finance the distributions they're required to make, mortgage REITs often do secondary offerings that often (though not always) risk potentially diluting the interest of existing shareholders. Along with Annaly and American Capital Agency, Invesco Mortgage Capital (NYS: IVR) and ARMOUR Residential (NYS: ARR) have seen extensive secondary offering activity in the past year -- activity that increases risk levels going forward. Add that to concerns about potential legislative changes to the mortgage REIT structure, and you'll find plenty of risk to go around.
Perhaps the most egregious example the article proposes is an immediate annuity. The article gives an example of a 65-year-old man turning a $200,000 annuity into payments of $1,100 monthly for life, which equates to a 6.6% yield.
What the article neglects to mention, though, is that in exchange for that yield, the annuity company gets to keep the entire $200,000 after the man's death. Saying that's equivalent to a near-7% "yield" is like saying that if you gave me $100 and I gave you $10 back every year for 10 years, you somehow earned a 10% yield.
Immediate annuities do have benefits for those seeking predictable lifelong income. But selling them as high-yield investments in this environment is misleading.
Stretching for yield is just about the worst thing you can do when rates are low. Perhaps the article's best advice comes when it talks about regular dividend stocks, as it ignores its own 7% target and recommends lower-yielding blue chips like Johnson & Johnson (NYS: JNJ) . But no matter what investments you pick, don't deceive yourself into thinking that any of your holdings is completely safe -- embracing risk is the only way to get healthy yields in today's market environment.
That said, it's clear that some dividend stocks are safer than others. Learn about 11 of the strongest in this free special report from The Motley Fool.
At the time this article was published Fool contributor Dan Caplinger stays safe -- most of the time. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Johnson & Johnson and Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position on Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps you as safe as it can.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.