These Investments Are No Free Lunch

If you depend on your portfolio to generate the cash flow you need to stay solvent, then rock-bottom interest rates have been your enemy for a long time. Before you jump ship to chase higher yields, though, you need to be comfortable with the added risk you may be taking on.

Next to nothing
The past couple of years have been disastrous for those who live off the income their savings generate. Although once hard-hit banks Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Wells Fargo (NYSE: WFC  ) have all worked their way back to profitability in the first quarter of 2010, you won't find them sharing much of their newfound wealth with their vanilla bank account clients. None of them offers a savings account yielding more than 1%, and many of their basic accounts pay far less.

Even if you're willing to tie up your money for a while, neither bank CDs nor Treasury bonds cut the mustard as far as income is concerned. Whereas just a few years ago, short-term rates were around 5%, it now takes a lot of work to get even close to that figure.

That said, it's not impossible. Kiplinger's Personal Finance recently listed a number of ways you can earn 5% on your investments. But before you jump into them, make sure you understand that they all carry risks.

Interest rate risk
With many fixed-income securities, the easy way to boost your yield is to commit your money for longer periods of time. Even for the maximum 30-year term, though, Treasuries won't get you to 5%; but other types of bonds will. Both corporate bonds and taxable Build America municipal bonds offer attractive rates right now. In addition, you can find preferred stocks that act a lot like long-term bonds, with features that call for regular dividends and an eventual return of capital that may be decades away.

The problem with these investments is that they're highly sensitive to changes in prevailing interest rates. Although the long-awaited return of higher interest rates has been put on hold during the recession, past economic cycles have seen healthy spikes in long-term rates. When that happens, both bonds and preferred stocks can lose substantial amounts of their value. And even if you own individual securities rather than funds or ETFs, you may have to hold them until they mature in order to avoid taking a capital loss.

Stock market risk
I've often encouraged investors to consider dividend stocks to generate part of their income. But they're not without risk. European oil giants Royal Dutch Shell (NYSE: RDS-B  ) and Total (NYSE: TOT  ) both yield around 6.6%, but each has faced the double-whammy of Europe's difficulties along with the BP oil spill. And having lost between 15% and 25% of their share value in just over a month, those oil companies show that dividend stocks clearly aren't a risk-free substitute that short-term investors should avail themselves of.

Industry risk
There's a hodge-podge of other types of investments that are designed to generate income. Master limited partnerships, for instance, take advantage of tax-favored treatment and regular cash flow from energy investments to build a strong stream of income that they pass through to investors. Real estate investment trusts take a similar approach with various types of commercial and residential real estate.

Each is vulnerable to conditions in its respective industry. For instance, Precision Drilling (NYSE: PDS  ) was a promising Canadian oilfield services company that was organized as a royalty trust. It paid lucrative dividends throughout much of its history, but had to suspend them when the bottom fell out of the natural gas market in late 2008.

Principal risk
In addition, you'll find certain mutual funds, especially closed-end funds, that use managed payout strategies to maintain high distribution yields. There, unfortunately, you can't count on the underlying investments these funds own to hold up their share of the bargain. Often, funds end up returning capital when they can't generate enough income. That's fine if you're prepared for it, but it means your principal may be steadily eroding even if you never sell shares.

There's always a price to pay
Even though some of these are smart investments, none of them are a perfect substitute for short-term savings. All too often, savers flock to these sorts of investments when most interest rates are low, only to suffer big losses when the interest rate cycle turns upward. Before you make any major moves, be sure you understand how the particular investments you're looking at work and what the potential downsides are.

There's a bubble coming, and it could cost you. Find out from Adam Wiederman where you should invest to avoid the threat of big losses.

Fool contributor Dan Caplinger sometimes misses the free lunches he used to get at his old employer. He doesn't own shares of the companies mentioned in this article. Precision Drilling is a Motley Fool Global Gains selection. Total is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never leaves you hungry.


Read/Post Comments (2) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2010, at 11:28 AM, tomd728 wrote:

    Dan,

    Thank you for another thoughtful piece.

    I believe that the Worldwide "issues" be it Iran,

    N.Korea v S.Korea, the Euro etc. etc. are giving us an extraordinary buying oppurtunity in quality

    stocks that have been beaten down by fear itself.

    Me ? I'll step up and make some money through dividends and appreciation starting with TOT.

    To keep it brief these guys have been there,done that,and will emerge with the goods.

    Respectfully,

    Tom Durkin

  • Report this Comment On June 06, 2010, at 5:44 AM, NewOldMoney wrote:

    AS will I. Buying TOT at under $46 is not seen too often and I'm with it!

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