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Income-hungry investors need investments to help provide the cash they need. With so many different income-focused investments, though, it's a challenge even to find out about all of them, let alone figure out which ones are most likely to thrive and which will wither away.
But one simple way to look at various types of income investments is to go back to basic economics and examine supply and demand. By identifying which assets have the most attractive supply-and-demand dynamics, you can predict the ones that have the greatest chance of holding their value -- and others that have excessive risk of losing value. Let's look at three popular places investors are looking to try to squeeze more income from their investments.
Mortgage-backed investments: signs of hope
Mortgage-backed securities have been on a tear in recent years, as falling interest rates have had their usual effect of increasing bond prices. Typically, though, mortgage-backed securities would underperform many other types of bond offerings because of the prepayment risk that mortgage-related investments have. Specifically, because homeowners can prepay their mortgages at any time, bondholders can end up having to accept their principal back earlier than they'd otherwise want -- especially when interest rates are falling.
Mortgage rates are still near multi-decade low levels, clearly indicating that there's money to be made by refinancing. But apparently, prepayments aren't happening at anywhere near the pace you'd expect. According to a report from BMO Capital Markets that examined prepayments data in detail, the recent drop in mortgage rates hasn't spurred an acceleration in prepayment activity. That may be because of difficulties in refinancing underwater mortgages and other inefficiencies in the mortgage market that are keeping homeowners from acting in their best interest.
Lower-than-expected prepayments are bad for the homeowners who can't take advantage of low rates, but they're great news for Annaly Capital (NYSE: NLY ) , American Capital Agency (Nasdaq: AGNC ) , and the other mortgage REITs that invest in mortgage-backed securities. As long as those trends continue, investors should enjoy above-market yields from mortgage-related investments.
Awash in corporate bonds
The supply and-demand situation is very different in the corporate bond arena. For years, companies have taken advantage of low interest rates to issue huge amounts of corporate debt. Just in the past week, Symantec (Nasdaq: SYMC ) , AT&T, and CBS were among big issuers of new investment-grade corporate bonds. Nor is this trend particularly new; earlier this year, Procter & Gamble (NYSE: PG ) and IBM (NYSE: IBM ) issued bonds at record-low levels for corporate issuers.
Perhaps most telling is the fact that in most cases, companies don't have any specific plans for the cash. Even cash-rich companies like Microsoft have raised debt, figuring that low rates were worth locking in even with billions in liquid funds on their balance sheets already.
So far, the huge demand for high-quality bonds has managed to soak up these large supplies of new issuance. But investors need to be cautious and look ahead to a time at which the credit markets won't be so willing to lend to any company seeking to raise capital. With thin spreads to Treasuries and low nominal rates that in many cases don't even beat inflation, bargains in the corporate bond market are getting harder and harder to find.
By contrast, municipal bonds are seeing restricted supply. With the rate situation not as attractive from issuers' standpoint, demand based on fears of higher future tax rates has put a price floor under the market.
In many cases, new issuance isn't even keeping up with maturities of existing muni bonds. As long as issuers don't respond with big new debt issues, prices of muni bonds could continue to get support.
Investing in income securities is particularly tricky in a low-rate environment because there's so much at stake if you're wrong. But looking at supply and demand is one way to give yourself an edge versus those who are simply buying bonds indiscriminately without paying attention to the fundamentals.
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