Investors are concerned about slower economic growth and undesirably high unemployment combined with softer inflation through the second quarter. In uneasy economic times, investors are more interested in living off the interest and dividends from their investments without touching principal. Investors, desperate for income, often inadvertently take on more risk.
Let’s take a look at many sources of income and break them down to show the advantages and disadvantages to holding each source:
Bonds
Between low interest rates and credit rating downgrades, we have talked about bonds in depth in the past few weeks. Bonds are typically considered low-risk investments, but the universe of bonds include government bonds, corporate bonds, municipal and junk bonds. With bonds, the only ways to obtain a higher rate of return is either move the yield to maturity further out, or move down the credit rating scale.
We generally look at high quality U.S. Treasury or municipal bonds with the intent to hold them to maturity. As per our Ten Year Rule, we plan for liquidity needs no longer than 10 years out. If you need the money within 10 years, we feel it should be in bonds. If you were to move money into bonds beyond 10 years, we feel you take on additional interest rate risk. If you opt to buy a 30-year bond paying a better interest rate with intentions to sell the bond in five years, you stand to lose if interest rates rise. When interest rates increase, the value of the bond decreases, thus, you may have to sell the bond for less than you paid for it. Therefore, the risk to holding long-term bonds is rising interest rates.
Certificates of Deposit (CDs)
Like bonds, CDs have a maturity date and a specified fixed interest rate, but can be issued in any denomination with terms ranging from one month to five years. They are savings certificate generally issued by banks and are FDIC insured. Also like bonds, CDs are risky because if interest rates rise, a CD holder is locked into payments lower than the current rates. We feel CDs make good short-term investments, and can be used until Treasury interest rates rise. Investors often keep emergency funds in CDs, but you should be aware there are typically penalties if cash is withdrawn from the CD before maturity.
Preferred Stock
Preferred stock is a hybrid security having features similar to both stocks and bonds. Like common stocks, preferred stocks represents partial ownership in a company, but do not come with voting rights. They also pay dividends at a specified rate; however, a company may suspend dividend payments to preferred stock owners. If you have cumulative preferred stock shares, you would receive skipped dividend payments if the company later resumes paying dividends. Non-cumulative shares do not receive skipped payments. Unlike common stock, preferred stock does not fluctuate very much in price. Since very little price fluctuation occurs, large short-term profits or losses are unlikely.
For these reasons, we do not recommend preferred stock. Preferred stock could go two to three years without paying dividends. Since shares do not fluctuate in price much, there is very little growth potential.
Royalty Trusts
Royalty trusts buy the right to royalties or net profits interests on the production and sale of oil, gas, and other natural resource properties or companies. They pass almost all of the profits to their investors. Royalty trusts are attractive because of the potential for high yields compared to stocks and bonds. However, they can be risky investments because they are tied to commodity prices and production levels.
Master Limited Partnerships (MLPs)
Master limited partnerships are also centered on the energy industry; however, they focus on the transportation and storing of those natural resources. MLPs can also derive income from real estate. What makes MLPs attractive is that income distributed avoids corporate tax and is only taxed at the partnership level. Since deductions such as depreciation and depletion are also passed through to individual partners, taxable income is often quite low.
Both royalty trusts and MLPs have advantages and disadvantages, but it is difficult to get quality research of what is going on inside the investment. Dividend percentages may also fluctuate in value, and of course your taxes may be complicated by these investments.
Real Estate Investment Trusts (REITS)
REITS offer professional management of a diversified portfolio of real estate investments, as they basically own income-producing real estate like apartment complexes, office buildings and shopping centers. They manage the properties, and when there is a sale, you may have capital gains. Of earnings, 90% are distributed to shareholders in the form of dividends. On the good side, they offer a liquid method for investing in real estate. On the bad side, the real estate market is a financially risky environment. REIT dividends are also taxed as ordinary income.
We own shares of Washington Real Estate Investment Trust (NYSE: WRE) in the Henssler Traditional Recommended Portfolio. As its name implies, the REIT is an owner and manager of real estate primarily in the Washington D.C. area. The company pays a nice dividend, with shares yielding more than 5%, annually.
Annuities
Annuities are generally sold as a way to accumulate assets for retirement or as a convenient method for delivering income during retirement. They generally come highly recommended by sales agents because agents often receive large commissions. Annuities are often advertised as “guarantee”—a term seldom used in finance. However, insurance companies can go bankrupt, and fail to pay the annuity contracts. There are plans in place in each state to ensure these failures are absorbed by other insurers; however, they usually are not funded until after problems occur.
Dividend Paying Stocks
While we sound like a broken record, preaching dividend paying stocks, the reality is stocks offer increased cash flow over time. They are not fixed, so the investments will fluctuate, but if you follow our Ten Year Rule, only money you do not need within the next 10 years is invested in stocks. Over the long term, the tendency is for stocks to increase in price.
We feel that dividends are relatively safe right now, in that many companies have three or four times in cash flow coverage for their dividends. As of August 18, 2011:
- Vodafone Group Plc (NASDAQ: VOD), yields 7.09%;
- Chevron Corp. (NYSE: CVX), yields 3.2%;
- Royal Dutch Shell Corp. (NYSE: RDS.A), yields 5%;
- Total S.A. (NYSE: TOT), yields 7.1%;
- Cincinnati Financial Corp. (NASDAQ: CINF), yields 6.1%;
- GlaxoSmithKline Plc. (NYSE: GSK), yields 4.94%;
- H. J. Heinz Co. (NYSE: HNZ) yields 3.67%, and
- Kraft Foods Inc. (NYSE: KFT) yields 3.36%.
We feel these are all strong companies with tremendous cash flow that will likely continue paying dividends. With the recent sell-off in the market, we feel investors could put together a portfolio of high quality companies yielding almost 5% in dividends. The average annual return for S&P 500 companies since 1920 is about 10%. Currently, you could make half of that in dividends. We feel these are good conditions to buy quality stocks at a discount, which many will not realize until it is too late.
At Henssler Financial, we believe you should Live Ready. That means fully understanding your investments, including both the benefits and risks. If you have questions regarding the investments you own, the experts at Henssler Financial will be glad to help. You may call our experts at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
