What's an Income Investor to Do?

Investing used to be a lot less complicated, especially for those who needed to draw an income from their portfolios. Not so many years ago, back when everyone extolled the virtues of the long-term 10% average return on stocks, you could get more than halfway to that double-digit percentage return just by picking a variety of government bonds or bank certificates of deposit. Even if you couldn't decide what to do with your money, doing some shopping to find the best cash savings account would give up 4% or 5%.

But the days of easy income investing are over, at least for the moment. Market Rates Insight reported last week that rates on five-year CDs fell below 1% for the first time in history. With inflation rates running well above that figure, CDs, Treasury bonds, and most other traditional income-paying investments simply don't pay enough even to hold their real after-inflation value, let alone help you improve the purchasing power of your assets. As a result, millions of investors are asking themselves: What should they do to enhance their income?

Disappearing income
When you look at your alternatives, you can see that throughout the income-investment world, it's tough to find the income levels that many people need. Consider just a few:

  • When it comes to ultra-safe investments, CDs aren't the only asset having trouble. Even with the recent rise in Treasury bond rates, five-year Treasuries pay only 0.8%. You have to go well beyond 10-year maturities to get returns above 2% -- and even those rates won't cover the effect of inflation.
  • Explicitly looking for inflation protection is equally fruitless for income investors. Treasury protected inflation securities, better known as TIPS, have negative yields until you go close to 20 years out. And unless you hold them in an IRA or other tax-favored account, those returns don't even reflect the impact of taxes on your overall return.
  • Municipal bonds trade roughly in line with Treasuries. Yet although they have the added benefit of being free of federal income tax, they also have arguably higher default risk, as recent episodes of municipal bankruptcies around the country have raised some concerns about whether bondholders will get repaid in full when their bonds mature.
  • Among bonds, only corporates give you anything resembling a decent return. But to get a good yield, you have to be comfortable taking on a decent amount of default risk.

The failure of bonds to pay decent income has pushed many investors to stocks. But even among some popular dividend-paying stocks, payouts have fallen recently. Popular mortgage REITS Chimera Investment (NYSE: CIM  ) and Annaly Capital (NYSE: NLY  ) have both made multiple dividend cuts in the past couple of years, as spreads between the amount they're able to earn on their mortgage-bond investments and what they pay on their short-term borrowings contract mildly.

The only place where income is rising
By contrast, the slowing economy has led a number of former growth companies to raise their dividends. Just last week, Cisco Systems (Nasdaq: CSCO  ) raised its dividend by 75%, joining the growing crowd of tech stocks paying yields of 3% or more. Seagate Technology (Nasdaq: STX  ) just hiked its payout again, making its quarterly dividend more than triple what it was less than five years ago. And of course, Apple (Nasdaq: AAPL  ) just paid its first dividend since 1995.

On one hand, this is good news for income investors. With tech stocks now paying more in dividends than any other sector of the market, you can no longer point at tech as an anomaly against shareholders seeking income.

But if these companies are giving up on producing further growth from their capital, it may bode ill for the sustainability of stock market advances over the long haul. After all, it usually takes capital for a company to grow, and so if a company voluntarily gives up its capital by paying a dividend, it signals a turning point in its growth cycle.

Watch out
At this point, many investors have little choice but to accept the risk that dividend stocks involve. But although dividends are in vogue now, income investors should watch carefully to make sure that they don't take on more risk than they can truly handle -- especially if conditions in the stock market start to deteriorate.

Dividends are a key way to earn income, but they're not the only way to a successful retirement. We've got some ideas on how you can invest for the long haul in the Motley Fool's special report on stocks that will help you retire rich. Get your free copy today while it lasts!

Also, Apple's got a lot more going for it than just its new dividend. Get the whole story from our top tech analysts with their views on Apple.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger is fortunate enough not to need much income from his portfolio at the moment. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital, Cisco Systems, and Apple. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always pays dividends.


Read/Post Comments (17) | Recommend This Article (56)

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 August 20, 2012, at 1:29 PM, Darwood11 wrote:

    Dan;

    Good article.

    The problem for all of us is "inflation protection" as you pointed out. In 2011 actual inflation was much higher than the return provided by most "cash equivalent" assets. I'm using an inflation rate of 1.85% for making that statement. My checking account and savings accounts lost money, if I take into account inflation.

    The current "yield environment" impacts everyone, be it "income investor" or anyone who has an emergency fund and a "cash stash." Last year, some stated that inflation was just north of 3%. Currently it's about 1.4%. The last time I checked, my cash accounts were giving me between 0.2% and 1.2%. "Ouch."

    My emergency fund will have to take a hit as I can't risk putting it into a higher yield and riskier environment such as stocks.

    Some might argue that the problem is simply adding an amount each year to that "cash stash" to make up for the loss in purchasing power due to inflation. That assumes that I'm getting a cash injection via a raise each year sufficient to make up the difference. But I'm not. So I can either underfund my "emergency fund" or pull in my horns and spend less.

    And the politicians wonder why the economy, which is 70% driven by the consumer, seems to be in idle? How about attributing it to a lack of common sense and critical thinking ability by our politicians? But that's a different subject.

    I'm not quite at the point where I have to live off of the proceeds of my investments, but your premise "what's an income investor to do" strikes a chord.

  • Report this Comment On August 20, 2012, at 5:15 PM, knob54 wrote:

    Try some newly issued REIT preferreds for above 6% income.

  • Report this Comment On August 20, 2012, at 6:05 PM, Seanickson wrote:

    what about housing? as the stock market has run up, the price of houses has run down. Housing is about as pure of an income play as there is. Theres more to investing than stocks and bonds.

  • Report this Comment On August 20, 2012, at 7:05 PM, PoundMutt wrote:

    I have a savings and loan 18 month Conventional IRA variable rate CD paying a MINIMUM interest rate of 3.0%. In addition, I can withdraw money AT ANY TIME WITHOUT penalty. I use this CD for my RMD and don't have to sell stock. Where did I go wrong!!!??? I also have my Home Equity Line of Credit with this S&L.

  • Report this Comment On August 20, 2012, at 7:13 PM, Seanickson wrote:

    nice, thats a very good CD. I assume that isnt something thats still available?

  • Report this Comment On August 20, 2012, at 8:07 PM, Bsorge10 wrote:

    Preferreds are very attractive, until you realize they often have no maturity date. That works against you in the long run.

    Right now dividend stocks look good, except the market had run up and prices ate too high.

  • Report this Comment On August 21, 2012, at 12:22 AM, carmel100 wrote:

    It was asked before,but I will ask again, why not housing, and getting a rent as income,yes I know all the problems you might get out of it (I did rent out properties in the past,and had quite a lot of problems with it) but now days what else can you do if you want or need an income of about 10% ??? One more question,what about holding Gold/Silver against the inflation??

  • Report this Comment On August 21, 2012, at 1:55 AM, sjg1 wrote:

    This article is totally wrong.. Vanguard inflation protection bonds went up 13.29% last year and many municipal bond funds did exceptionally well (the median muni national long fund gained 10.7% in 2011). Statistics per Morningstar.

  • Report this Comment On August 21, 2012, at 7:59 PM, EASYMONEY00 wrote:

    I loaded up up on 6-7% preferreds well below the call price a year ago and that turned out to be a great move.

  • Report this Comment On August 21, 2012, at 8:50 PM, TMFGalagan wrote:

    @seanickson - Rental housing is definitely an option for some, although you have to be in the right market. Also, it's an active occupation in many cases - not the sort of thing you can treat as a passive investment unless you pay a management company for the privilege.

    best,

    dan (TMF Galagan)

  • Report this Comment On August 21, 2012, at 8:51 PM, TMFGalagan wrote:

    @carmel100 - Gold and silver sometimes have worked as an inflation hedge, but lately, their movements don't seem to follow it. You had a big rise in the past 10 years despite low inflation levels.

    best,

    dan (TMF Galagan)

  • Report this Comment On August 21, 2012, at 8:51 PM, TMFGalagan wrote:

    @sjg1 - Your return information is past performance rather than current yield. If rates keep falling, then yes, TIPS and munis could continue rising in price. But the yields are lousy.

    best,

    dan (TMF Galagan)

  • Report this Comment On August 21, 2012, at 11:29 PM, tbyrd58 wrote:

    I've been able to keep a dividend stock portfolio yielding over 4% on some blue chips, but you have to hunt to get some at a decent price. Some of the stocks I got when their P/E was under 15 now have a P/E of close to 20 or over.

  • Report this Comment On August 21, 2012, at 11:30 PM, tbyrd58 wrote:

    That's not total yield, but just dividend yield.

  • Report this Comment On August 22, 2012, at 10:28 PM, sodapops wrote:

    Put a decent portion of your savings in stocks that pay a dividend and have a solid history of raising that dividend by something over 5% every year.

  • Report this Comment On August 24, 2012, at 11:50 AM, shoe53 wrote:

    Dan, I also think you should have mentioned preferred stocks,obviously not as safe as CD's and municipals but many offer 6-7% dvidends. If one plans on holding them several years, I think it is even worth paying up to 1-2% over par value. Have owned quite a few for several years and only a couple of times were they called so still came out well since I pay very small online trading fees. I think quantumonline.com is a good,free website to use to find preferred stocks and other income investments.And bankrate.com is good to shop for CD's.

  • Report this Comment On August 24, 2012, at 6:45 PM, 2motley4words wrote:

    Hello, shoe53: I'm interested oin lowering my trading fees; would you be willing to tell me which online broker you use (and your overall opinion of it)? Thanks.

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