Understanding Yields And Alternative Investments

Low yields are crimping investment income. You don’t need me to tell you how low yields are on money market funds and treasury bonds. Yet, income investors need to be mindful that rates are likely to rise as the economy improves. Reach for higher yields now by purchasing long-term bonds, and you could suffer a loss of principal when rates rise.

This dilemma is leading many investors to search for income alternatives, and several vehicles are attracting a lot of attention. Let’s take a look at the pros and cons of these investments.

Stable value funds. These are the successors to guaranteed investment contacts (GICs), which were popular in the 1980s. The sponsor of the fund guarantees that the net asset value of the stable value fund shares will be constant. In addition, a yield similar to that of intermediate bonds is earned by the shares.

While often compared to money market funds in advertising, stable value funds aren’t similar. Stable value funds tend to hold bonds with an average maturity of two and a half to three years. Money market funds generally hold debt with maturities of one year or less and have an average maturity of 30 to 90 days.

To keep the net asset value stable and to avoid having to sell investments before maturity, stable asset funds limit access. Some allow redemptions only on certain schedules. Others impose stiff redemption fees on those who want their money back before a minimum time. Scudder PreservationPlus Income Fund charges a 2% redemption fee when the yield on a published bond index exceeds the fund’s annual yield by 1.55% or more. The idea is to keep investors from leaving to grab the latest high yielding opportunity and, especially, to discourage sales after interest rates rise. Most stable value funds also allow purchases only through 401(k)s and IRAs.

Because of the limited liquidity, stable value funds are more like certificates of deposit than like money market funds or bond funds.

Higher fees also are a price you pay for the stable value guarantee. Of course, any guarantee is only as good as the firm backing it.

If you shop for a stable value fund, keep in mind that the yield quoted probably isn’t what you actually will earn. Quoted yields are backward-looking. They reflect what the fund recently earned. In a falling interest rate environment, new investors will earn less than the quoted yield.

Principal-protected securities. These investments promise to at least maintain the value of your principal if you hold the investment for five to seven years. You also have the potential of appreciation if the stock market rises during the holding period.

The firms sponsoring these securities generally achieve their results by purchasing zero coupon bonds with most of your investment and buying stock index futures with the rest. The zero coupon bonds ensure a minimum value at maturity, and the futures will rise or fall with the stock market. The investments pay no income or dividends.

PPSs generally have high expenses that are deducted from your protected principal. Also, there usually is a limit to the appreciation that will be credited to your shares.

Of course, there are redemption fees if you want the money back early, and sales charges of 5% or so on purchases. Many of the funds provide the guarantee only if you redeem the shares on one specific day. The insurance purchased to pay the guarantee is expensive, making many of these funds essentially very high expense bond funds.

Over five to seven years, a properly diversified portfolio usually has at least retains its original value and retains the possibility of earning gains from its equities. You can do this with low expenses. Or you can buy your own portfolio of zero coupon bonds or bond funds and buy a few stock futures of your own.

Ultra short bond funds. These bond funds have average maturities of two years or less. They also promote themselves as alternatives to money market funds, but there are differences.

You do have liquidity in most short-term bond funds. Shares can be redeemed daily without a redemption fee. The funds also earn yields much higher than those of money market funds. Today, many ultra-short bond funds earn yields from 3% to 4%, while money market fund yields are less than 2%, sometimes substantially less.

The higher yields are earned by taking higher risk. Ultra short bond funds often buy debt from corporations with less-than-pristine credit ratings. The higher yielding short-term bond funds will have 25% or more of their portfolios in corporate bonds. When the economic outlook dims or a company reports earnings problems, the bonds lose value. The bonds also lose a little value if market interest rates rise. Look at its total return, not just the recent yield. In 2002, most ultra short bond funds had total returns of less than their yields of 3% to 4%, because the shares lost value.

An ultra-short bond fund or even a short-term bond fund should be used for money that won’t be needed for at least a year.

Floating rate funds. The advantage of these funds is that the yield adjusts automatically with market interest rates. The funds don’t own traditional bonds. Instead, they buy flexible rate loans that banks made to businesses. The disadvantage is that the businesses tend to have low credit ratings. In most of these funds, also known as prime rate or adjustable rate funds, the yields are not high enough to offset principal losses.

Preferred stock. I’ve discussed these hybrids between stocks and bonds in past visits. Let’s look at some highlights and current issues.

Preferred stocks have yields of 6% to 8%, and some have higher yields. The market for preferreds is fairly small and illiquid. The stocks can be tough to buy and tougher to sell. The best bet is to buy new issues and hold them until they are called (redeemed). Their values will fluctuate with interest rates. You have to ignore the fluctuations by planning to take your dividends and hold the shares until called.

There are few mutual funds that concentrate in preferreds. Those that do are closed-end funds that must be purchased through a broker. Most of these use leverage that increases your risk and have occasional “rights offerings” that are confusing and affect the value of your investment. They also sell at premiums or discounts to their net asset value, depending on whether preferreds are popular or not. Right now, many sell at premiums because investors want the higher yields.

The only preferred mutual fund I’ve recommended is Preferred Income Fund (PFD) and its sibling fund Preferred Income Opportunity Fund (PFO). Each fund now sells at a premium to net asset value, so I don’t recommend buying them.

A unique problem now is that few new issues of preferred stock are being issued. Things are on hold while Congress decides on the President’s proposal to make dividends tax free. In addition, corporations are calling or redeeming existing preferred stock to take advantage of lower interest rates.

In times of low interest rates, too many investors reach for higher yields by taking more risk than they realize. Financial firms issue new products that are confusing but appear to offer higher yields and safety. Be sure you fully understand an investment before being tempted by a yield, and understand what will happen if interest rates rise.