How to invest in a low-interest-rate world

COMMENTARY In Wednesday's Wall Street Journal, Burton Malkiel's op-ed noted that low bond yields have left some investors restless for better alternatives. One of his suggestions may help you navigate tough markets, while the other two require a much deeper look.

The overall theme of his article is that bond holders will likely be disappointed with their returns for the next several years. He then suggests a few alternatives: holding tax-exempt municipal bonds; holding foreign bonds from countries with balance sheets stronger than the U.S.'s; or holding a portfolio of blue-chip, high-dividend stocks. Let's take a closer look at the alternatives he suggested.

The 30-year bull market in bonds is over
Why a high-dividend stock strategy isn't a good approach
Municipal bonds buck bad news with solid returns

Tax-exempt municipal bonds

Malkiel is right about the value of tax-exempt municipal bonds. At almost all maturities, municipal bonds have higher yields than Treasuries even before accounting for the tax advantage. Certainly, this isn't normal, as the market would typically demand a premium for tax-exempt municipals due to the tax advantages. At some point, you would expect this to revert back to the historical case. Also, tax-exempt munies are probably not the best choice for tax-deferred accounts, as CD yields are higher than tax-exempt municipal yields.

However, I don't agree with Malkiel that the reason you're seeing higher yields is mostly because of higher credit risk in the municipal market. Instead, I see three other possible reasons:

-- Treasuries are more liquid than municipal bonds, thus giving municipal bonds a liquidity premium.
-- Treasuries are the natural choice in flight to quality environments.
-- There's a touch of taxation uncertainty surrounding President Obama's proposal to make tax-exempt municipals federally taxable for some investors.

Foreign bonds

There are two reasons why non-dollar bonds are not a good substitute for high quality U.S. dollar fixed income securities. For one, leaving currency risk unhedged means that these positions will be much more volatile than domestic bonds, because the currency return is very volatile. Another reason is that this trade tends to be highly correlated with the equity market, meaning it tends to do poorly when the stock market is doing poorly.

The exact trade he is suggesting is the perfect example. Malkiel used Australia as an example, noting that the country had a debt-to-GDP ratio of about 25 percent, plus a young population and abundant natural resources. In the third quarter 2011, the S&P 500 Index was down about 14 percent. However, buying Australian bonds and leaving the currency risk unhedged was down about 10 percent, because the Australian dollar depreciated against the U.S. dollar by about that amount. This is exactly what you tend to see with what Burton is suggesting. When there's a flight to quality, the dollar tends to appreciate against other currencies. As a consequence, non-dollar bonds can have negative returns.

Dividend-paying stocks

In this case, swapping out high-quality bonds for stocks that pay high dividends defeats the purpose of having bonds in the first place. One of the main purposes of bonds is to provide shelter when the market drops. However, just when you need the protection the most, it may vanish.

Think back to March 2009, which was the tail end of the market crash. In the previous six months, 46 companies had cut their dividends, compared with 17 companies in all of 2007. Even blue-chip stocks, which Malkiel recommends, couldn't avoid cuts:

-- General Electric announced its first dividend cut in February 2009, a cut of 68 percent.
-- Pfizer announced a 50 percent dividend cut in January 2009.
-- Newell Rubbermaid announced two dividend cuts in three months, with the second announcement on March 24, 2009.

Further, high-dividend-yielding stocks are still stocks and can be expected to depreciate significantly in value in periods of stock market stress (unlike high-quality bonds). This is why you should focus on total returns (dividends plus capital appreciation or depreciation), not just dividends. Another reason for focusing on total returns is that an extreme focus on high-dividend stocks leads to an undiversified portfolio, because a large number of companies do not pay dividends.

In this case, stick with Malkiel's suggestion about tax-exempt municipal bonds. Make sure they are high quality, meaning they have a rating of AAA or AA (or even A if they have a maturity of three years or less). Also make sure they're from strong sectors, such as general obligation or essential service revenue bonds. If you still need more return to reach your financial goals, you'll likely be better served by increasing your allocation to a well-diversified stock portfolio as opposed to following Burton's recommendation to consider non-dollar bonds or high-dividend stocks.