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The economy has been recovering on paper for the past several years, but for many Americans, times are still tough. Trying to do personal budgeting is particularly difficult when you can't even be confident that you'll be able to keep your current job, let alone expect a raise. And for those who have already retired, the pittance of additional money that Social Security will provide next year doesn't begin to cover many of the rising costs that most seniors face.
As a result, more people are turning to their investments as a place from which to draw much-needed income. But unless you want to see your portfolio dwindle to nothing in future years, you need to make sure that the amount of investment income you can reasonably expect matches up with your actual needs. If it doesn't, then you'll need to consider whether you need to make some changes to your investment strategy.
The income crisis
For the past several years, interest rates have been at record lows. With the Federal Reserve having originally decided to cut its key short-term Fed Funds rate to near 0% in order to support the flagging economy, many income-producing investments whose rates are tied to the Fed Funds rate have steadily declined. Moreover, given the tepid pace of recovery and the Fed's continuing efforts to try to reinvigorate the economy, savers could face several years before a more normal economic cycle reasserts itself and takes interest rates back up again.
In practical terms, what all this means is that bank CDs that paid 5% or 6% five years ago now pay 1% to 2%. Savings accounts that paid 4% or more are now almost universally below the 1% level. Most money market mutual funds pay less than a tenth of a percent in interest. In other words, traditional sources of income for conservative investors have dried up, leaving a big gap in budgets that rely on portfolio income to make ends meet.
The risks and rewards of higher income
To replace that lost income, you have to consider how much income you really need as well as how much additional risk you're willing to take on. If 4% to 5% is enough to supplement other sources of income, then you can find a host of traditional blue chip stocks that offer not only ample dividend income but also good future prospects for share-price appreciation. For example, Altria (NYSE: MO ) yields more than 5% right now, based in part on fears that stricter regulation will continue to weigh on sales. But longer-term, shares have followed the company's dividend higher, and with all the pessimism around the stock, any positive surprise could push the stock upward strongly. Oil giant ConocoPhillips (NYSE: COP ) is similarly secure, with a 4.5% dividend yield and plenty of upside if energy prices remain strong.
On the other hand, if you need significantly more income from your portfolio to make ends meet, then you'll have to look further afield. Some high-yield bonds offer payouts of 6% or more, although part of that is meant to cover the higher risk of default that these bonds carry compared to bonds from the U.S. Treasury and other higher-rated issuers. Among stocks, business development companies Apollo Investment (NASDAQ: AINV ) and Prospect Capital (NASDAQ: PSEC ) pay double-digit dividend yields, profiting from the same sorts of deals that private equity firms make. When BDCs make investments that pan out, their shareholders reap the rewards. But as the experience of American Capital (NASDAQ: ACAS ) shows, when things go wrong for BDCs, dividends can disappear. American Capital hasn't paid any dividend at all in four years.
Get what you need
How much risk you're willing to take on is a decision only you can make. But if your personal budgeting calls for more income than you'll get from your job, Social Security, or any other sources you have, then your investments need to pick up the slack. By adding the right investments, your portfolio can do its part to help you stay on budget without dipping into your hard-earned principal.
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