With interest rates down around zero, finding income-producing investments is tougher than ever. The Federal Reserve's current monetary policy has been particularly tough on retirees who rely on fixed-income instruments whose value is tied to interest rates, like bonds.
The new year is always a great time to reassess investment goals and your portfolio. If you are a retiree who needs steady income, consider something different in 2021: dividend stocks.
Income, but no upside
Corporate and municipal bonds used to be a decent source of return, back when interest rates were higher. Investment-grade corporate bonds paid mid-to-high-single-digit returns prior to the 2008 financial crisis. But rates are now close to zero. Once a bond is trading around par (or about 100 cents on the dollar) it kind of sits there until it matures, especially if the interest rate on the bond is close to market rates. And most corporate bonds have a call provision, which means the company can force you to sell it back at a certain price, usually around 2% to 3% above face value.
So while your upside in bonds is capped, the downside is still 100%, especially for any bond with credit risk. Your only source of return is whatever meager interest rate the bond is paying.
Take a look at the chart below. The current yield for high-quality investment grade bonds is 2.26%. The yield for those rated BB (i.e., junk bonds) is 3.45%. So the upside is capped, and the income isn't great enough to make up for it. Luckily, bonds aren't the only game in town for earning income.
Dividend stocks: Income plus upside
Income investors should turn to the stock market for yield. Dividend-paying stocks give you income, and they don't have the capped upside that a bond does. A bond isn't going to go much above 100 cents on the dollar; stocks don't have that issue. Luckily, there are plenty of high-quality dividend payers that give you a higher yield, plus the potential for capital gains.
The Dividend Aristocrats are always a great place to start looking for income-producing stocks. These are companies that have raised their dividend every year for at least 25 years. Some of the Dividend Aristocrats are venerable names like 3M (MMM -2.86%), with a 3.4% yield; Consolidated Edison (ED 0.80%), with a 4.3% yield; or Realty Income (O 1.32%), with a 4.6% yield. Compared to an investment in junk bonds, these stocks provide a better yield as well as capital gains potential. They're also reasonably defensive in nature. In other words, they will be less affected by a recession than cyclical and consumer discretionary stocks will.
While Dividend Aristocrats have the benefit of stability, there are other potential investments with high yields. Mortgage real estate investment trusts (mREITs) include some stocks with double-digit dividend yields, like Annaly Capital Management (NLY -0.16%) at 10.3%. Annaly buys mortgage-backed securities that are guaranteed by the U.S. government. If the economy rolls over and borrowers get behind on their mortgages, Annaly still gets paid. The stock suffered early in the year with the volatility in the bond market but seems to have found its footing.
Inflation: Down, but not out?
There is one other consideration for income investors. While inflation has been too low for the Fed's tastes for several years, the Fed is pulling out all the stops to create it. Eventually it will succeed. Inflation erodes the purchasing power of the dollar, and it's the enemy of every bond investor. Inflation is less of an issue for a dividend-paying stock in that the company can raise prices, which can increase profits and potential dividends. With a bond, the rate you get will never increase. Investors with a lot of bonds sitting at or above par should think hard about those investments.