The markets are down, and that is a good time to consider adding some spice to your portfolio. Our recommended portfolios hold investments with a margin of safety and the opportunity for solid, steady profits. For those of you who want to branch out, I’ve found additional opportunities. One of these investments carries more risk but with the potential for higher returns. This is a good time to seize that opportunity. The other investments are more conservative income vehicles than we have in the regular portfolios. I’m not putting these into the recommended portfolios now. But they might be right for a number of you to add to your investment accounts.
When the economy declines, so do high yield bonds. These corporate bonds pay above average yields, because the corporations issuing them aren’t the financially strongest. A small percentage of the corporations will default on the bonds, but most pay off. That’s why high yield bonds should be purchased only through a mutual fund whose managers can analyze the issuing corporations, keep the default rate to a minimum, and diversify their bond holdings.
High yield bonds are most attractive when the gap between their yields and regular corporate yields is wide. This is one of those times. The gap first ballooned to historic levels in November and December 2000. But the gap closed quickly, since most investors were optimistic about an economic recovery. Investors aren’t so optimistic now, and the gap is closing slowly. Defaults are rising, and experts expect the default rate to rise for at least another year.
You can earn yields of over 10% on high yield bonds. With a carefully-selected portfolio of these bonds, the high yields will more than pay for the low percentage of defaults. High yield bonds might find their way into the Sector and Balanced Managed Portfolios in coming months.
My favorite high-yield bond fund is Columbia High Yield (800-547-1707). It has an impressive long-term record compared with its competitors. I also like Vanguard High Yield (the most conservative fund in the category) and Northeast Investors Trust (800-225-6704).
In the past I’ve pointed income investors to preferred stock. Preferred stock pays higher yields than bonds, because if the firm goes bankrupt bond holders get first shot at the assets. But only a small percentage of companies fail to pay dividends on their preferred stock or go bankrupt. The higher the yield on an issue of preferred stock, the more precarious the issuing company’s financial situation. The value of the preferred stock will bounce up and down with interest rates, much like long-term bonds. But that matters only if you plan to sell before the company redeems the stock.
There is not an open-end mutual fund that concentrates in preferred stock, and I don’t recommend that most investors try to pick a diverse portfolio of preferreds. Instead, choose one of the closed-end mutual funds that specialize in them and trade on the exchanges like stocks. I recommend Preferred Income Fund (PFD).
Do you want safe income with inflation protection? The federal government offers two opportunities to achieve these twin goals.
I-bonds are inflation-indexed U.S. savings bonds. These are 30-year bonds that currently yield 5.92% (compare with a five-year CD yield of 4.55%). The rates are recalculated each May and November based on a guaranteed rate currently at 3% (which might drop in November) plus the inflation rate. In addition to the inflation protection, the interest is exempt from state and local taxes, and federal income taxes can be deferred up to 30 years or until redemption. The bonds can be redeemed anytime after five years, or earlier by paying a three-month interest penalty. If the proceeds pay college tuition, the interest can be exempt.
If you are considering safe investments such as CDs and money market funds, take a look at I-bonds. The interest rate will fall when it is set in November, but it still should beat the super-safe alternatives. But don’t buy I-bonds if you need regular income payments.
In the first year, your purchases are limited to $30,000 per Social Security number. I-bonds are sold in denominations from $50 to $10,000. Check www.savingsbonds.gov or contact your bank.
TIPS (Treasury Inflation-Protected Securities) are a cousin of I-bonds. TIPS are treasury bonds with semiannual payments and inflation protection. The yield on the bonds is determined by market prices for the bonds. Then the principal of your bonds is increased annually by the Consumer Price Index rate. Unlike other inflation hedges, such as gold and real estate, this adjustment is automatic and doesn’t vary with the supply and demand for the investment.
There are potential disadvantages to TIPS. The annual adjustment in the principal is treated by the IRS the same as an interest payment. You must include the adjustment in your income for the year, though you won’t get the cash until the bonds are redeemed or sold. That makes tax-deferred accounts best for TIPS.
TIPS are traded on the markets. Sometimes the bonds sell at low prices relative to other bonds, and sometimes you can sell them for a nice premium. That won’t matter if you buy direct from the Treasury and hold them until maturity. Right now, TIPS are trading in the markets at attractive prices.
You can purchase TIPS directly from the Treasury at www.publicdebt.gov. Or you can buy mutual funds that specialize in TIPS such as American Century Inflation-Adjusted Treasury Fund (800-345-3533), 59 Wall Street Inflation Indexed Securities Fund (800-625-5759), PIMCO Real Return Bond Fund (888-877-4626), and Vanguard Inflation-Protected Securities Fund (800-662-7447). Pimco has better returns but charges a 3% load. American Century’s fund is the better choice.