In my last article, I discussed the quandary bond investors face today in search of income. Over the past 30 years, investors were accustomed to a predictable source of income while enjoying stable prices, but rising interest rates make this trickier today. Bond yields are at near record lows, and when rates rise, bond prices fall. Investors must prepare their portfolios for rising interest rates.
There are several alternatives to bonds for investment income, but you need to understand some of their risks before investing. The data used in this article come primarily from the Morningstar database of funds. I highlight several investments without identifying them by name because I use them for reference purposes, not as actual investment recommendations.
Business Development Companies (BDC)
As banks tightened lending standards the past few years, businesses turned to BDC’s for needed capital. BDC’s can invest through debt or equity. One publicly traded BDC has a dividend yield that averaged 11.80% from 2010-2012, making it attractive as an alternative income source, but it also comes with several risks. A BDC investing in equity doesn’t have the same creditor protection as a bondholder if a company goes bankrupt. Another risk is price volatility. The BDC I mentioned above has a stock price that is over two times as volatile as the S&P 500. For investors used to the steady prices of bonds, BDC’s can be a wild ride.
Non-traded BDC’s are available, which means its shares aren’t traded on a stock exchange. Since it’s not listed you won’t see day-to-day price fluctuations, but they’re non-liquid. If you need to redeem shares to raise cash for other expenses, you may not be able to sell when you need to. The risk of non-liquidity should limit the amount to invest in any non-traded security, regardless of the redemption provisions at the time of investment.
Closed-End Mutual Funds (CEF)
CEF’s are mutual funds with a fixed number of shares, and Morningstar tracks 603 of them. CEF’s can use financial leverage to boost yields, but that makes the fund even more susceptible to rising interest rates. For example, one highly-rated fund in Morningstar's database has a very attractive yield over 7.0%. But it also uses over 40% financial leverage and its share price has fallen over 15% this year. Don’t be lured into a closed-end fund as an easy solution for income.
Also known as “below investment grade” or less subtly as “junk bonds,” high-yield bonds pay a higher yield because of their higher default risk. One of the largest high-yield bond funds has a 12-month yield of 6.91%. In addition to higher yields and default rates, junk bonds also have higher price volatility. As yields have fallen over the last few years, some investors blindly put a large portion of their portfolios in high-yield to capture the yield, without realizing the inherent risks. Default rates have been low lately, although questions remain about municipal bonds due to woefully underfunded pension and healthcare obligations in most locales.
Investing in dividend-paying stocks for income is a strategy that has been used for decades. Companies that pay a dividend are generally well-established companies with stock prices that are less volatile than those of small companies. However, investing in stocks will significantly change the risk profile of your portfolio, so this is not a simple substitute for bonds. Also, buying overvalued stocks increases the risk further in the event of a price correction.
None of the asset classes listed above can solely replace bonds, but these, along with other investment strategies, can help build a diversified portfolio to produce income through interest, dividends and capital gains.