Income Investors Face Challenges as Economy Shifts
Andrew Leckey

The search for high yields presents a quandary for income investors.

If interest rates rise in the future, the value of high-yield, longer-term bonds bought now will decline. But if a high-dividend-paying stock is chosen, the investor needs to be relatively sure that today's impressive dividend is here to stay.

"The economy continues to recover globally and a few months from now, when more data is in and people get comfortable with the reality of a recovery, the Federal Reserve could raise interest rates," predicted John Berrick, director of research for U.S. Global Investors, San Antonio. "That would be a positive sign that the recovery is real."

The potential rising-rate scenario makes Berrick more interested in stocks than bonds, and primarily high-quality large-cap companies with predictable futures.

His favorite stocks with dividends around 6 percent are telecommunications firms AT&T Inc. (T) and Verizon Communications (VZ). In health care stocks with dividends of 4 percent or more, he likes Eli Lilly & Co. (LLY), Merck & Co. (MRK) and Pfizer Inc. (PFE).

"Whether you realize it or not, if you're chasing yield you're chasing risk--since the market doesn't give anything away," asserted Kelley Wright, managing editor of Investment Quality Trends newsletter, Carlsbad, Calif. "High-yield bonds have already enjoyed really big returns and aren't going to get anywhere near that level going forward."

Like Berrick, Wright includes the stock of AT&T among his favorites. Though acknowledging that tobacco firm Altria Group (MO) is indeed a "sin stock," he recommends it for its dividend yield of more than 6 percent and the fact it is in a "simple business that doesn't require much technology." Diversified energy company ONEOK Inc. (OKE) offers a yield of almost 4 percent, while utilities Southern Co. (SO) and FirstEnergy Corp. (FE) each yield more than 5 percent.

Despite the allure of dividend-paying stocks these days, bonds remain a major player in most investment portfolios.

"Money flowed into bond funds and out of stock funds last year because investors were seeking lower risk and more income," explained Michael Boone, president of M.W. Boone and Associates, Bellevue, Wash. "The two ways you can increase bond yield are to stretch the maturity rate on the investment or to take on more credit risk."

With interest rates at record lows, investors can see the danger of locking in long-term rates that could escalate later. Any added risk is usually taken on gradually, with a move out of government-backed investments the first step, said Boone. Next, shift from AAA government bonds to AA or A bonds, rather than jumping right into junk bonds, he advised.

A more aggressive income bond fund is T. Rowe Price Corporate Income Fund (PRPIX) with a 12-month return of 24 percent and a three-year annualized return of 5 percent. Its portfolio has an average corporate bond maturity of 10 years.

More than half of its assets are in BBB-rated bonds, which is twice the exposure to that less-than-perfect class that most of its rivals hold. Junk bonds usually make up more than 10 percent of this fund's portfolio of more than 350 bonds.

Unlike competitors that invest heavily in government bonds, T. Rowe Price Corporate Income holds the debt of companies such as Morgan Stanley, Goldman Sachs (the subject of a high-profile Securities and Exchange Commission civil charge regarding mortgage securities it sold), Time Warner, American Tower and Citigroup. This no-load fund requires an initial minimum investment of $2,500 and an annual expense ratio of .73 percent.

"Some stocks are yielding pretty nice dividends right now," pointed out Boone, who especially likes the reasonably-priced stocks of telecommunications firms. "If your view is that rates are going up, the only way to keep up with that is to have growing dividends."

Investors must keep in mind there is risk in individual stocks because even companies with long histories of reliably paying dividends could suspend them. That's why it's important to consider factors such as the debt on a firm's balance sheet, he said.

"If a company is making a lot of money but paying out a small percentage in dividends, then there's a good chance the dividend will be there a pretty long time," Boone explained. "But if it is paying out every spare dollar in dividends, you should beware because that dividend is likely to be cut in lean times."

In stocks, Berrick also recommends the dividend yield of over 3 percent and potential for price appreciation of E.I. DuPont de Nemours & Co. (DD) and Lockheed Martin Corp. (LMT).

His firm's U.S. Global Investors All American Equity Fund (GBTFX), which is up 32 percent over the past 12 months with a three-year annualized decline of 4 percent, holds a portfolio of about 60 well-known stocks. The largest holdings include Apple Inc., Salesforce.com Inc., Medco Health Solutions Inc. and American Tower Corp.

That "no-load" (no sales charge) fund requires a $5,000 minimum initial investment and an expense ratio of 1.77 percent.

Finally, turning to an exchange-traded fund, Vanguard Dividend Appreciation ETF (VIG), with a 12-month return of 39 percent and a relatively flat three-year annualized return, holds a diversified portfolio of nearly 200 high-quality U.S. large-cap equities. Its top holdings include Wells Fargo Corp., IBM, Coca-Cola Co., PepsiCo Inc. and Johnson & Johnson. Its expense ratio is a low 0.23 percent.