Last Updated Nov 19, 2009 12:23 PM EST
Investors are paying a steep price for safety. It's understandable, given recent market history, that you might be focused more on protecting your cash than investing it for growth. But consider the numbers: The average taxable money market fund yields about .09 percent (in other words, zilch). The average rate on a three-month CD is roughly .75 percent, which is also zilch when you realize that the quoted payout is annualized; over three months you actually get one fourth of that, then you pay tax on it.
Sure, by shopping around for yield, you can do a little better, but you’ll still be earning less than long-term inflation rates. To find a true cash alternative returning more than 3 percent, you have to lock in a CD for four years or longer.
By moving a little further out on the risk curve, however, you can find attractive investments with fairly juicy payouts. Blue chip dividend stocks and high-quality bonds, for instance, will pay you 3 to 6 percent and still allow you to sleep at night. While these investment options are too volatile for money you plan to spend in the next year or two, they are fairly conservative investments. Here’s a guide to your choices, from most to least volatile.
Stocks with juicy dividends can provide income, potential capital gains, and, as CBS MoneyWatch blogger Charlie Farrell has written, a hedge against future inflation. What’s more, dividends are taxed at 15 percent, while those puny bank interest payments are taxed at ordinary income rates. So if you are in a higher bracket, you’ll keep more of your dividend income.
The downside, of course, is that share prices can fall. “The stock market currently offers lots of opportunities to boost yield,” says John Buckingham, chief investment officer for Al Frank Asset Management in Laguna Beach, Calif. “But you have to be willing to stomach volatility.”
To be sure, the payouts are not guaranteed. While companies are loath to cut dividends, some 250 firms slashed their dividends in the second quarter, the most since 1957. Among the recent dividend cutters: such seemingly solid companies as Wells Fargo, Dow Chemical and Pfizer. Dividend payments by companies in the S&P 500 are down 32 percent from July 2008.
That said, many businesses have maintained or increased their payments, despite the financial storm. “A lot of companies that are still paying good yields— say, 3 to 6 percent — have come through the economic challenges,” says Josh Peters, editor of Morningstar’s DividendInvestor newsletter. “Their stocks shouldn’t give you a lot of heartburn.”
Avoid stocks with exceptionally high yields—these days, higher than 6 percent or so. “It may sound good to get a 15 percent yield, but generally that’s not going to be sustainable,” says Buckingham. “You don’t tend to get that kind of yield unless there’s something wrong.” Witness BreitBurn Energy Partners: Shares yielded 27 percent in early spring, but the company suspended the dividend in April.
Also, check the stock’s “payout ratio,” or the percentage of a company’s earnings paid in dividends (available at Reuters Finance). Peters notes that a company may have trouble sustaining a payout higher than about 60 percent of earnings. (Utilities, which commonly pay out as much as 80 percent, are an exception.) Peters recommends Waste Management (WMI; 3.93 percent yield) as an example of a firm with a dependable payout. “It’s scheduled to pay 60 percent of earnings this year,” he says. “That’s a good figure in a recession, when earnings are down.”
Companies with competitive advantages are likely to be able to protect their earnings and dividend payments. Peters says pharmaceutical giants Johnson & Johnson (JNJ; 3.21 percent) and Abbott Laboratories (ABT; 3.57 percent) are two with strong brands, pricing power, diversified revenue streams and excellent patent protection.
Buckingham favors defense contractor General Dynamics (GD; 3 percent) and electric utility Edison International (EIX; 3.76 percent). He believes their solid balance sheets and payout ratios of 22 percent and 35 percent, respectively, suggest they’re unlikely to slash dividends, and may have room to boost them in the future.
Dividend-seeking investors who would rather not buy individual stocks should consider an equity-income or balanced fund. Just show considerable skepticism of the published dividend yields of these portfolios. Funds calculate yields based on payouts over the previous 12 months, and, given the recent dividend slashing, many are likely to pay less during the coming year.
Look for no-load funds whose mission is to find companies with rock-solid balance sheets that haven’t cut dividends. Stick with funds with expense ratios below 1 percent; you’ll find the figure in a fund’s prospectus. The lower the ratio, the more of the yield you keep.
T. Rowe Price Equity Income Fund (PRFDX; 2.99 percent yield; 0.69 percent expense ratio) focuses on low-priced shares of financially strong companies—a recipe for healthy, sustainable yield. The venerable Vanguard Wellington Income Fund (VWELX; 3.85 percent yield; 0.29 percent expense ratio; minimum investment: $10,000) holds roughly 60 percent of its portfolio in high-quality, dividend-paying stocks, and about 40 percent in high-quality corporate bonds.
Many short- and intermediate-term no-load bond funds offer nearly as much stability as cash, with much higher yields. It’s difficult, and expensive, to build your own bond portfolio, so for most investors a fund is the way to go. Focus on funds that hold bonds with credit ratings of A or higher. Although lower-rated bonds may yield more, they also carry a higher risk of default. “The worst may be behind us,” says Peter Palfrey, co-portfolio manager of the Loomis Sayles Core Plus Bond Fund. “But we’re still looking at a very, very severe economic downturn, so I’d suggest investing conservatively.”
Ginnie Mae Funds
These portfolios, which hold mortgage securities backed by the full faith and credit of the U.S. government, yield more than Treasury funds, notes Tony Crescenzi, strategist and portfolio manager at PIMCO. So you can earn a higher return without taking on extra risk. Fidelity Ginnie Mae (FGMNX; 4.65 percent yield; 0.45 percent expense ratio) combines low expenses and a solid track record. By contrast, Fidelity’s Treasury-only sibling, Fidelity Intermediate Government, now yields 2.57 percent.
Municipal Bond Funds
Muni bonds offer federal-tax-free income, a deal that gets sweeter as your tax bracket gets higher. Because of the tax advantage, munis usually yield less than Treasury bonds, but thanks to unusual conditions in the bond market, many munis actually boast higher yields than Treasuries right now, even before accounting for taxes. One fund to consider: Vanguard Intermediate-Term Tax-Exempt (VWITX; 4 percent yield; 0.15 percent expense ratio). Investors in the 28 percent tax bracket (taxable income of $137,050 to $208,850 for married couples; $82,250 to $171,550 for singles) would have to earn more than 5.56 percent on a taxable bond fund to beat that 4 percent tax-free yield. Residents of high-tax states should consider state-specific funds, whose payouts can be state- and even city-tax free as well.
Diversified Bond Funds
Portfolio managers with the freedom to invest across fixed-income markets, buying corporate bonds, mortgage-backed securities and global debt, can produce even higher returns. The inclusion of corporate and foreign bonds, however, means these funds are somewhat riskier than funds that own only government-backed securities. One worthy candidate: Dodge & Cox Income (DODIX; 5.72 percent yield; 0.43 percent expense ratio).
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