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Here's the bad news for fixed-income investors: A 10-year Treasury note recently paid a 3.55% yield. Inflation in February, as measured by the Consumer Price Index, climbed at a 4% annual rate.
So the real yield, after inflation, on a 10-year Treasury is a negative 0.45%. Yep, buy a Treasury and lose ground to inflation. Just what an investor building a retirement nest egg doesn't need.
Here's the worse news for fixed-income investors: The price of a 10-year Treasury note is likely to fall in 2009. Although the Federal Reserve may wind up cutting interest rates again and again in 2008 in an effort to prop up the economy, expect interest rates to be headed higher in 2009 as the central bank switches to fighting inflation.
Yep, buy a Treasury and the value of your holdings will fall as higher interest rates push down bond prices. Just what an investor building a retirement nest egg doesn't need.
No doubt about it, these are excruciating times for fixed-income investors. In the current market, risk is up and yield is down. Looking a few years out, it's hard to see how higher inflation and rising interest rates won't eat away at the value of today's investments.
And all this is happening just as the huge baby-boom generation is starting to retire, which will gradually drive up demand for safe, fixed-income investments.
Fixing the problem
But don't despair. I think there's a way out that will enable you to keep up with inflation -- and more -- and that will let you grow the yields of your income investments over time. I'm calling this miracle strategy "unfixed-income" investing. And over the next few months I'll build an unfixed-income portfolio to help you implement that strategy.(I'm going to keep my current Dividend Stocks for Income Investors portfolio up for a few more months as I gradually build this new portfolio, but by summer I expect to replace that list with my unfixed-income portfolio.)
So how does unfixed-income investing work?
Like my dividend-stocks portfolio, this strategy starts with common stocks that pay high dividends. The goal I set in October 2005: Find equity investments with yields above the percentage paid by the 10-year Treasury note and that are safer than the 10-year Treasury under current market conditions.
That strategy has been a solid success: In a period when yields have been falling, my dividend-stocks portfolio has returned an annualized 13.5% -- that's dividends plus price appreciation (if any) and minus commissions.
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That stacks up nicely against the 5.8% average annual return (with dividends) on the Standard & Poor's 500 Index ($INX) for the period that ended April 8 and the essentially flat performance of such bond market mutual funds as Fidelity Total Bond (FTBFX) and Vanguard Institutional Bond Market Index (VITBX).
But for my unfixed-income strategy, I'm going to add a wrinkle. Instead of just looking for common stocks that are yielding more than the 10-year Treasury note, and are safer, I'm going to add a third criterion: superior histories of raising dividends year in and year out.
This last requirement gives income investors a fighting chance to beat today's low yields and stay ahead of future inflation. How does it work? By putting the power of dividend compounding to work for long-term-income investors.
Let me use US Bancorp (USB, news, msgs) as an example. This stock is my first pick for my unfixed-income portfolio. Until that portfolio is fully launched, I'll make the stock part of my dividend-stocks portfolio and track it there. I'll use the cash from selling the last six-month certificate of deposit in that portfolio for this purchase.
The yield on US Bancorp -- 5.24% on April 10 -- is certainly high enough to make the cut. And this conservatively run bank is certainly safe enough.
The company did take a $115 million ding when it bought back some debt securities owned by its money market funds, but that's been about the extent of the damage in the current financial crisis. Loans 90 days or more past due increased to 0.74% in December 2007 from 0.57% in December 2006, and analysts expect charge-offs for bad loans could grow to 1% of total loans this year and next.
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But those figures are low enough to convince me that the bank will ride through the downturn in housing and commercial lending without any big problems. It doesn't hurt that this is one of the most profitable banks in the country, with return on equity well above 20% year in and year out.
But it is US Bancorp's commitment to returning 80% of earnings to shareholders that makes it the first stock in my unfixed-income portfolio. Combine that commitment with the bank's steady rate of earnings growth -- 8.5% annually over the past five years -- and what you get is a stock with constantly increasing dividends for shareholders.
In 2003, the stock paid 86 cents a share in dividends. For 2008, the dividend payment has climbed steadily to $1.70 a share, an increase of 98%.
That's impressive enough, but look at what the power of dividend compounding has done to US Bancorp's dividend yield in that time. At the end of 2003 you could have bought the stock's then 86-cent-a-share dividend for $29.15, for a yield of 2.95%. By April 9, because of the current financial crisis, the share price had fallen back to $32.48 from nearly $36. Thanks to the growth in the company's dividend per share, the yield is now 5.24%.
Continued: Track records matter
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