“We look for high-yielding funds and ETFs for two main reasons. First, we know that some subscribers need income for their living expenses. Second, an appealing dividend yield or interest rate may indicate that the investment in question is a bargain, and thus ripe for attractive total return (price gain plus interest and/or dividends). However, finding attractive securities with high payouts isn’t as easy as just looking at the yields. Sometimes, yields are high for the wrong reasons, including high risk of credit downgrades or default in the case of bonds or, in the case of stocks, unattractive reinvestment opportunities or a high risk of a dividend cut. High payouts from high-quality securities are relatively scarce today. As virtually every investor and saver knows, yields on money-market funds and certificates of deposit are miniscule, which means that such investments are losing money after inflation.
“Yields are so low on short-term bond funds that holders will actually lose money on most of them after inflation, especially if held in regular accounts outside a retirement plan, unless the funds produce capital gains. (It’s fine to hold these as portfolio stabilizers, just don’t expect much in the way of total return from current levels.) In financial parlance, this means that real yields are negative. They aren’t much better on longer-term bond funds. A real yield on these of 1.5% to 2.5% is paltry, given the potential for yields to rise and prices to fall on existing intermediate- and long-term high-quality bonds. So, what’s an income- oriented investor to do? It appears to us as if two types of investments offer attractive yields and reasonable risk in the current environment: high-yield bond funds and utility stocks.
“Many of our Best Buys portfolios have benefited handsomely from positions in high-yield bond funds. ... Of course, yields were so high for these funds a year ago because of the poor overall performance of high- yield bonds in 2008, when the financial and credit crisis caused them to experience huge drops in price. Now, since the high-yield sector has produced such a huge rally, yields are considerably lower. ... However, we think the high-yield sector continues to offer a relatively attractive yield even with its risk profile. The difference in yields between high-yield bonds on the one hand and the 10-year U.S. Treasury on the other is now somewhere around 550 basis points (5.5 percentage points), which is about average for the past 20 years or so. Given the improving state of the U.S. economy, we think that’s enough of a spread to justify positions in one or more of the relatively conservative high-yield bond funds available, like the ones we recommend. Plus, were interest rates to rise on Treasuries and other investment- grade securities as the economy improves or inflationary expectations increase, high-yield corporate bonds would likely lose less than these other types of bonds.
“Utilities are today’s most unloved sector of the U.S. equity market. Their dividend yields are high relative to the market, and their valuations are low. SPDR S&P Select Utilities (see page 10) the largest utilities ETF by assets, has a dividend yield (as of March 1, 2010) of 4.31%, vs. about 1.8% for the S&P 500, and a price/ earnings ratio of less than 12 on projected earnings for 2010, vs. more than 14 for the market.
“After holding up relatively well against the sagging stock market in 2008, utility stocks have lagged far behind the broader market and most other sectors during the subsequent recovery. That’s not all that surprising though, actually. In the early stage of a big market rebound, defensive sectors like utilities usually lag. However, now that the huge gains in a short period of time are probably over for the market this cycle, utilities are not at too much of a disadvantage anymore. In fact, when you consider its dividend yield, valuations and low volatility (a beta of only about 0.63 against the S&P 500), the utility sector may be the best bargain around now. ...
“Utilities have several important things going for them that are likely to help their stock prices. One, despite the long-term trend toward more energy efficiency, electricity demand will rebound to some degree as the economy improves. Two, generating and transmitting electricity, natural gas or water are capital-intensive endeavors, so the return of functioning credit markets and lower borrowing costs eases the financial crunch on utilities, many of which have massive projects underway or slated to begin. Three, as long as interest rates don’t increase dramatically, utilities’ dividends are that much more appealing.
“Compared to yields on investment-grade bond funds, utility dividend yields are even more attractive on an after-tax basis. Dividends are taxed at a peak rate of only 15% until 2011, and political considerations suggest that 20% is about as high as the top dividend tax rate is likely to go afterwards.”
Mark Salzinger, No-Load Fund Investor
