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Specializing in retirement planning and personalized investment management.

Income Focused Investments

Income Focused Investements

In this low interest rate environment, it’s reasonable to look for ways to increase the income from your portfolio.  Here are some investment ideas for those seeking a higher yield:

High Yield Bonds
 
A high yield bond fund may pay out 2.5% or more vs. a comparable-term investment grade bond fund.

We like to allocate about 9% - 10% of our bond allocation to high yield bonds.  This means that high yield bonds make up between 1% and 7.5% of our overall target portfolio allocations (more bonds means more high yield).  Example - A 30% stock portfolio has 6% in high yield, while a 70% stock portfolio only has 2% in high yield, yet high yield makes up about 9.5% of the bond allocation in each portfolio.

The idea here isn’t to add high yield to the portfolio, but to add more, to a degree.  We wouldn’t want to load up on high yield bonds, but it may be reasonable to go from 5% to 8%, etc.  While that may increase your income, it also adds to risk, since bonds that pay higher interest are riskier than investment grade bonds.  Just make sure you understand the trade-offs. 

There are a few ways to mitigate your risk with high yield bonds:

  • Don’t buy individual bonds or a concentrated fund with only a few holdings
  • Buy a fund that is shorter term, therefore somewhat lessening your exposure
  • Buy a target maturity fund that holds bonds for a certain date
  • Buy a fund that has a higher credit rating vs. its peers

Master Limited Partnerships (MLPs)

MLPs can offer yields comparable to high yield bonds (more income), and stock market returns (potential growth).

Like high yield bonds, we like to allocate a certain percentage (usually 4%) to MLPs in our target portfolios.  These investments typically focus on energy infrastructure (oil and natural gas pipelines, etc.) and have a “toll road” business model.

Here too, the idea is to hold more MLPs to increase yield.  Diversification and trimming other “alternative” investments can help mitigate some of the risks.

Real Estate Fund

Like high yield bonds and MLPs, we can choose to add more real estate to the portfolio.  We could either hold more of our standard recommended funds, or we could add a new component.

Global real estate (U.S. and international) is generally yielding a little over 3%.  While that’s decent in today’s environment, some closed-end real estate funds are yielding 6% or more.  The closed-end funds are usually a little more concentrated and their performance has slightly lagged our standard recommended real estate funds, but they do provide higher current income.  Closed-end funds may also trade at a discount or premium compared to the Net Asset Value (NAV) of the investments held by the fund.
When adding a closed-end real estate fund to the portfolio, we would usually reduce the amount going into one of our standard recommended real estate funds.  We view them as complimentary to the real estate asset class and not a core component (meaning we usually wouldn’t hold just closed-end funds for the real estate component of a portfolio).

Dividend Focused Fund

Dividend focused funds hold stocks of higher dividend paying companies.  Dividend focused funds are typically classified as Large Value.  Compared to one of our standard recommended large value funds, dividend focused funds can pay about 1% higher yield, but they are more concentrated and have lagged slightly in performance.

Since dividend focused funds are considered large value funds, when adding one to a portfolio, we would usually reduce the amount going into one of our standard recommended large value funds.  We view them as complimentary to the large value asset class and not a core component.

Utilities Fund

Utilities funds hold stock of utility companies.  Utilities funds are typically classified as Large Value.  Compared to one of our standard recommended large value funds, utilities funds can pay about 1.5% higher yield, but they are more concentrated and have lagged in performance (sometimes by wide margins).  Utilities funds are generally less volatile than most stock funds though, so they could be thought of as a somewhat defensive play as well.

Since utilities funds are considered Large Value funds, when adding one to a portfolio, we would usually reduce the amount going into one of our standard recommended large value funds.  We view them as complimentary to the large value asset class and not a core component.

Preferred Stock Fund

Compared to common stock, preferred stock has priority on the earnings (guaranteed dividends paid before common stock) and assets (in case of bankruptcy) of a company.  However, preferred stock usually has less potential for appreciation.  Preferred stock is sometimes referred to as a “hybrid” investment since it has both stock and bond characteristics.

Preferred stock funds can offer a yield of 6% or higher.  They are not highly correlated to stocks or bonds, so they can also provide some diversification.  However, preferred stock funds have several risks:

  • Highly concentrated with as much as 90% in financial companies
  • Usually the companies have a lower credit rating
  • Very sensitive to interest rate movements, like long-term bonds

We classify preferred stock funds as large value stocks in our allocation. When adding one to a portfolio, we would usually reduce the amount going into one of our standard recommended large value funds.  We view them as complimentary to the large value asset class and not a core component.

Covered Calls

A covered call is an options strategy where a person sells a call option on a stock position they own to generate extra income.  A call option is a contract that gives a buyer the right to buy 100 shares of a certain stock at a certain price before an expiration date.  The buyer pays a premium (money) to the seller in exchange for this right. This is extra income to the seller.

Example – Emily buys 100 shares of ABC stock for $40/share ($4,000 total).  While she thinks the stock has good long-term potential, she also wants to generate an immediate return and offset possible losses with a covered call.  In the market she finds that she can sell a $45/share 9-month call option on ABC for $3/share (prices vary depending on factors like share price and length of time on the option).

Scenario #1 – Within 6 months, ABC stock appreciates to $50 and the buyer exercises the call option.  Emily would receive $45/share (since that is the strike price) + $3/share for selling the call option, for a total of $48/share, or $4,800 total.

Scenario #2 – ABC stock drops to $32/share.  In this scenario, the option is not exercised because it is not above $45.  Emily has a loss of $8/share ($40 - $32), however, she also received $3/share for the call option, so her real loss is only $5/share.

Covered calls provide current income and some offset to losses in market downturns, but your upside is limited too (you will underperform in bull markets since the appreciated stocks will be called away and you are only paid a portion of the appreciation). 

We prefer a fund which specializes in covered calls instead of buying individual stocks and selling covered calls yourself.  These funds can yield 7% or more. They are usually considered large blend funds, so when adding one to a portfolio, we would usually reduce the amount going into one of our standard recommended large blend funds.  We view them as complimentary to the large blend asset class and not a core component.