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How to Find Income in a Low Interest Rate World

This post was updated on June 13
Money managers gathered in Chicago for the annual Morningstar Investment Conference last week were unanimous that Treasury Bonds are a lousy investment, but few are finding exciting alternatives. "You're almost guaranteed to lose money" when you invest in U.S. government bonds, after accounting for inflation and taxes, said Peng Chen, president of Morningstar's global investment management division, echoing earlier remarks by Pimco founder Bill Gross.

After six straight weeks of losses in the stock market, the alternatives to bonds don't look so good. But the long-term math of Treasurys is even uglier.

The basic case against bonds is that their yields are so low your money won't grow fast enough to keep up with inflation. And if yields should rise, and you're stuck with an old, lower-yielding bond, you can't sell it without taking a loss. In other words, you only have two options -- lose money slowly or lose money fast.

That conundrum is a big problem for individual investors seeking safe income, especially retirees, for whom safety is crucial. And unfortunately, none of the money mangers or financial planners at Morningstar offered a perfect alternative. You can find decent yields if you are willing to give up safety, but you have to make the tradeoff.

Ross Levin, a Minnesota-based certified financial planner, said he has been putting clients in 5-year Ally Bank CDs that yield nearly 2.5 percent, not a windfall, but more than an equivalent bond. They are backed by the FDIC, and thanks to a fairly small penalty for early withdrawal -- two months interest -- it's an investment that's almost as liquid as cash. MoneyWatch blogger Allan Roth has been recommending similar high-yield CDs.

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If there was any consensus on better places to get income in your portfolio, most managers seemed to like dividend-paying stocks, though of course with stocks you risk losing your principal. As the economy slows, and the bull market of the past two years wobbles, investors are seeing value in big blue chip companies - the kind that pay dividends. Shares of those companies have not climbed as high as shares of smaller companies since the market bottom, so in addition to offering a payout, those stocks today look cheap.

Both Gross and Josh Peters, an equity strategist at Morningstar, mentioned Proctor and Gamble (PG), which yields 3.2 percent, and has a history of hiking dividends. If the dividend keeps climbing, their thinking goes, you stay ahead of inflation, plus you stand to reap capital gains if the share price goes up.

BlackRock CEO Larry Fink called U.S. stocks one of the "most under-invested asset classes out there." He warned that if federal budget deficits are cut by the $4 trillion that some in Congress have suggested, growth will slow, and, by extension, stock returns will be reduced. But he said that annual average returns of 4 percent would be a reasonable expectation.

Despite the general dislike of Treasury bonds, few managers were predicting a principal-killing spike in yields any time soon. With global growth slowing and the Federal Reserve keeping rates at rock bottom, Rick Reider, a chief investment officer of fixed income at Blackrock, argued that Treasury bond prices could stay low for a long time. But some managers said they'd rather accept the near zero return of cash than own bonds and take the risk that yields jump.

Among the other options for producing income are master limited partnerships, companies that own pipelines and are structured to pass almost all their income on to investors. MLPs, which make money whether gas prices rise or fall, have had a stellar decade, so they don't yield as much as they used to. But Peters said he liked Energy Transfer Partners (ETP), which pays nearly 8 percent. He said utilities are looking a little pricey, but still likes American Electric Power (AEP), which yields just under 5 percent.

Ben Inker, head of the asset allocation group at GMO in Boston, said low yields were a global problem, and that Australia and New Zealand were about the only countries offering a decent combination of safety and yield. GMO, he said was heavily invested in U.S. blue chip stocks. And, he said, the firm has a significant cash position -- "dry powder" for the next time the market stumbles and offers a buying opportunity.

While Inker didn't name any particular asset class that he felt was primed to crash, he did say he saw signs of a bubble in China. The world's most populous nation, he said, is using 53 percent of the world's cement -- more cement per capita than any other nation in history. "Unless they are planning to pave all of China, that may be unsustainable," he said.

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