3 Income Investing Ideas: Dividend Stocks, High Yield Bonds, MLPs

September 20th, 2012 by

(September 2012) While our parents’ generation may have expected their retirement to last 10 or 15 years, couples today expect their retirements to last 27 years on average (according to a survey by investment manager BlackRock). The change in expectations is logical considering that the average life expectancy in United States has risen dramatically over the last 30 or 40 years.

Much longer retirements represent a major financial challenge. With a 30 year time horizon, the ability to drawdown on principal to support living expenses becomes a much less practical strategy. Retirees are going to need to support themselves without eating into their principal. That means they are going to need to find investments which generate lots of income.

The current economic environment makes this challenge very tough. Yields on treasury bonds are near zero and investment grade corporate bonds are yielding well below 5%. These traditional vehicles for income are in many cases yielding below the expected rate of inflation. In other words, in real terms, investors will be losing money by investing in traditional fixed income products. The question is where should income focused investors / retirees put their funds?

BlackRock held an investment roundtable to address this topic on September 19th in New York, featuring 3 portfolio managers. Here is some of the things they said:

The Dividend Guy (David Cassese) – Portfolio Manager for BlackRock’s Equity Dividend Fund (MDDVX)

Names He Finds Interesting: IBM, VFC

Advice: Don’t go for the highest dividend paying stocks. Go with stocks that pay an attractive dividend and consistently grow it.

Pitch: You want to own a quality company with good growth prospects. When you buy a company that pays a high dividend but does not have history of consistently raising dividends, you can often end up with a company in trouble. Often, the dividend is high only because the stock price has been beaten up and there may be a big dividend cut coming. On the other hand, a company that raises its dividend is making a strong positive statement about what it thinks about its future prospects, as reversing a dividend increase carries a major stigma for the company AND its management.

Interesting Fact: David mentioned that dividend increases have historically outpaced the rate of inflation by 1 – 1.5%, providing a positive real return (without taking into account price appreciation.)


 
The Multi-Asset Guy (Michael Fredericks)  - Portfolio Manager for BlackRock’s Multi-Asset Income Fund (BAICX)

Sectors He Finds Interesting: Asian Telcos, Natural Gas Infrastructure MLPs

Advice: There are good places where you can earn 5% in dividends and income/interest distributions. However, you have to expand your horizons beyond traditional bond funds that track the Barclays US Aggregate Bond Index.

Pitch: His fund can invest in a combination of Non-Agency Mortgages, Emerging Market Equities, MLPs, high-yield bonds, preferred stocks and  dividend paying stocks.  The fund currently yields around 5.25%. Right now, Michael is very excited by the enormous discoveries of natural gas in the United States and believes there is an investing opportunity in this sector. Investors can buy MLPs (master limited partnerships) which invest in drilling for natural gas or infrastructure companies that transport and store gas. Michael prefers the infrastructure MLPs because they have less volatile earnings.

Interesting Fact: Preferred stocks have duration risk just like bonds. In fact, Michael estimated that the typical preferred stock in his portfolio had a duration of 5.5 years.  If you own preferred stocks and interest rates rise, be aware that preferred stocks can lose value even when common shares are rising.

The High Yield Guy (James Keenan) – Portfolio Manager for Blackrock’s High Yield Bond Fund (BHYAX)

Bonds He Finds Interesting: Energy Future Intermediate Holdings (a subsidiary of TXU), Sprint-Nextel Bonds

Advice: The world is a much safer place for high yield investors than two years or even one year ago. The biggest market uncertainty, how central banks would react to a continued US economic sluggishness and European turmoil, is now clear.

Pitch: Why would anyone invest in treasuries over high yield bonds? With the 5 year treasury yielding under 1.0% and high-yield bonds over 6.0%, there is a difference of over 500 bps. In very basic terms, for treasuries to be a better investment than high-yield, the default rate on high yield would have to reach 9.0% per year.  (When a bond defaults, the bond holder normally recovers through bankruptcy about 40% of the bond’s face value.)  Before the FED and ECB made clear their intention to support the market on an ongoing basis, there was a chance that credit would dry up for risky borrowers triggering a wave of defaults (as companies could not refinance debt or would need more capital than they had to do business.) With this risk heavily diminished, James sees defaults in the low single digits. Ergo, high-yield bonds are a superior investment to treasuries.

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