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What should income investors do now to maximize returns and minimize risk?
Right now, you can easily find a six-month or 12-month CD yielding 5.25%. With very little work, you can do even better: The highest yield I could find with a low $1,000 to $2,500 minimum was 5.65% on Oct. 24.
With a six-month CD beating the yield on a three-month Treasury bill (5.10% on Oct. 23) and on a 10-year Treasury note (4.8%) and on such high-yield blue chips as Bank of America (BAC, news, msgs) (4.17%) and Royal Dutch Shell (RDS.A, news, msgs) (3.81%), why bother to look any further?
To beat the yield of a government-insured CD in the stock market, you'd have to own something like an Italian phone company such as Telecom Italia (TI, news, msgs) (6.02%). Considering the extra risk, it hardly seems worth it.
Why not just load up on CDs at current rates, sit back and play it safe?
Because in a year like the one ahead, even CDs come with their own set of risks. Because the interest-rate picture is so uncertain for 2007, I think you can't just load up an income portfolio with CDs. That will expose you to risk that you might not even recognize until it's too late. Despite higher yields on CDs, income investors need to stay committed to building a balanced portfolio of income-producing assets so they can manage the risks of 2007.
So in this column I'm going to update for 2007 the income portfolio that I started on Oct. 14, 2005.
I launched this portfolio for income investors with my column "5 energy stocks for income investors" because I thought income investors could use whatever help I could offer in a very tough market environment. Yields weren't very tempting in October 2005; in fact, if you looked at the 4.5% yield on the 10-year Treasury note, they were downright disappointing. And as if that weren't enough, the Federal Reserve was firmly locked into a series of interest rate increases well into 2006 that would knock down the price of any bond an income investor bought.
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I updated that five-stock portfolio in December 2005, adding three high-yield stocks for a total of eight and dividing the rest of my cash, $20,000, between a six-month and a 12-month CD. And in April 2006, I updated the portfolio again.
You can find a partial accounting of the returns on this portfolio by following the link to "Dividend Stocks for Income Investors" in the left-hand margin of this column. But that tool only captures part of the score, since it doesn't track the two preferred stocks in the portfolio and doesn't include income from the CDs I purchased in December.
Here's a more complete accounting:
| Security name | Date purchased | Purchase price | Total return as of 10/24/06 |
|---|---|---|---|
10/14/2005 | $51.03 | -5.5% | |
10/14/2005 | $32.62 | 26.2% | |
10/14/2005 | $58.33 | -1.9% | |
10/14/2005 | $45.70 | 12% | |
5/17/2006 | $49.05 | 21.8% | |
10/14/2005 | $26.99 | 4.8% | |
12/6/2005 | $40.69 | 1.6% | |
12/6/2005 | $25.21 | 3.3% | |
12/6/2005 | $101.58 | -1.7% | |
**6-month CD, yield 4.5% | 12/6/2005 | 3.8% | |
12-month CD, yield 4.77% | 12/6/2005 | 4% | |
Total portfolio return (Assumes equal $ positions; income not reinvested, trading commissions deducted) | 6.8% |
*Northern Border Partners was renamed Oneok Partners on May 17, 2006.
**6-month CD rolled over on May 6, 2006.
My December purchase of those two CDs has worked out quite well. With interest rates climbing, when I rolled over the six-month CD in May 2006, I was able to get a higher yield. The same thing would happen if I choose to roll over the 12-month CD this December -- the yield is likely to be almost a full percentage point higher than the yield I received when I bought back in December 2005.
And that, of course, tells you where the risk in CDs lies now. It's not asset-specific risk, since CDs are insured. It's not market risk, since we're going to hold to maturity and CD values don't fluctuate in a secondary market like bonds do. No, the potential risk is reinvestment risk: If, as the bond market sometimes thinks, a weakening economy in 2007 forces the Federal Reserve to cut interest rates in 2007, then any investor rolling over a CD purchased today will confront lower rates at the time of rollover. It's called reinvestment risk, and it's a source of risk to any income investor at any time.
But reinvestment risk is an especially important class of risk to consider right now because the direction of interest rates in 2007 is so uncertain.
- If the economy slows more than expected -- slipping, say, below 1.5% GDP growth -- and threatens to start down the path to recession in 2007, then the Federal Reserve will cut interest rates to prevent an economic meltdown. Back in September, not especially long ago even for the financial markets, bond traders were pretty much counting on a cut in interest rates in 2007.
- If, on the other hand, the economy stays stronger than expected, accelerating back toward 3.5% growth, that will send up a red flag on inflation. And with inflation already running hotter than the Federal Reserve would like at close to 3% in recent months, Ben Bernanke and company are likely to raise interest rates. That creates two drastically opposed scenarios for income investors in 2007.
- If the Federal Reserve cuts interest rates, the price of existing bonds and higher-yielding stocks will go up. Falling interest rates mean that anything with an existing higher yield becomes more valuable, so its price goes up. The longer the maturity of the higher yielding asset, the more its price will climb. At the same time, since the Fed is cutting rates because the economy is slowing, some companies will see revenue and profits fall. That in turn will raise the possibility that some companies will have to cut dividends or at least reduce the rate at which they have been raising dividend payouts in recent good times. And, of course, with interest rates falling, income investors face rising reinvestment risk.
- If, on the other hand, the Federal Reserve decides to fight inflation and slow an economy growing faster than expected, higher interest rates will depress the price of fixed-yield instruments such as bonds. Stock prices might suffer as well -- they often do as interest rates rise -- but earnings at companies highly leveraged to economic growth would climb faster than expectations. Reinvestment risk would disappear and rolling over short-term CDs would be a winning strategy, since each rollover would increase the yield of your portfolio.
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