Where to find investing income beyond bonds

It’s no secret the past few years have been abysmal for investors seeking income. Though considered to be province mostly of retirees and near retirees, income equities are a sizeable portion of asset allocation for nearly all sorts of investors, young, middle age, institutional endowments, and the like.

With interest rates still at historic lows, the yield on the most common income asset, U.S. Treasurys, have been absolutely terrible. The common “4% rule” for retirement withdrawals could never cope long term at today’s yield.

But a funny thing happened over the last few years — the rest of the world just sort of fell apart, according to the bond market. Though interest rates are near zero and yields pitiful, total returns on bonds have been surprisingly good. According to Morningstar, the iShares 7-10 Yr Treasury ETF IEF, -0.38% has a five-year return of 5.5% and a one-year return of 5.03%. Similarly the iShares US Aggregate Bond ETF AGG, -0.25% had a five-year return of 3.38% and a one-year return of 3.2%. Low, but higher than you might expect considering the ZIRP environment.
This was driven by global fear and disappointment in other markets: the EU crisis, declines in emerging-market currencies, a slowdown in China and quantitative-easing policies sweeping the world. These trends supported bond prices, masking the low yield. For example, five years ago IEF was trading at only $82.50 versus $106.70 today, a 30% gain, and AGG was at $92 versus $110.20 today, a 20% gain.
With interest rates all but certain to be raised by year end in the U.S., with promises of continual increases afterwards, bond prices will inevitable fall from their highs. The markets have recently shown signs of this change, dropping 3%-5% over the last few months and wiping almost $1.2 trillion from the global bond market. Though calls for a bond-market collapse have been years in coming now, risk is high and prudence suggests considering the role of alternative income assets in your portfolio. But which ones?

Stable dividend-paying stocks have traditionally been a strong alternative. Using the benchmark yields of IEF at 2% and AGG at 2.28% (for reference, S&P 500 yields 1.87%), how do other market sectors compare? First, consider the major equity market sectors as represented by the SPDR Select Sector ETFs, covering materials to financials to health care.

Symbol Sector 12-month yield
XLE Energy 2.48%
XLU Utilities 3.42%
XLK Technology 1.71%
XLB Materials 1.88%
XLP Consumer staples 2.55%
XLY Consumer discretionary 1.30%
XLI Industrials 1.94%
XLV Health care 1.23%
XLF Financials 1.65%
Even though bond yields are low, most stock yields aren’t much better. Only energy, utilities and consumer staples have superior yields.

Looking on the downside, using the five-year trailing standard deviation from Morningstar, it’s clear the stock ETFs jump around. Though dividend yields are 10%-50% higher, they also have a two times to five times larger degree of movement. While standard deviation only measures magnitude of changes in stock price and not the chance of making or losing money, it still is a valuable indication of risk.

Symbol Sector Standard deviation (5-year) Returns (5-year annualized)
IEF 7-10 year Treasurys 5.92% 4.46%
AGG Bond aggregate 2.83% 3.38%
XlU Utilities 13.52% 13.05%
XLE Energy 14.34% 10.58%
XLP Consumer staples 9.99% 15.97%
Moving on to other alternatives, the explosion in ETFs the last few years also means there’s a wealth of income choices many never considered before such as preferred shares ETF and real estate (REIT). For preferred shares, the iShares US Preferred stock ETF PFF, -0.08% is by far the largest at $13 billion in assets and the 2nd being the Powershares Preferred Portfolio PGX, -0.14% at $2.8 billion.

While preferred shares have their own advantages and disadvantages compared to bonds and stocks, many preferred stock ETF (almost always in financials) sport impressive yields, almost triple bonds, but with relatively similar standard deviations. Though they don’t appreciate in price like stocks, they do offer great yields and moderate volatility benefits.

Symbol Description 12-month yield Standard deviation (5-year) Returns (5-year annualized)
PFF iShares Preferred Stock 6.04% 6.60% 8.39%
PGX Powershares Preferred Portfolio 5.96% 4.95% 8.51%
PGF Financial Preferred Portfolio 5.79% 7.64% 9.54%
PSK SPDR Wells Fargo Preferred Stock 5.25% 5.85% 7.77%
Another more recently popular asset class is REITs, with dozens offering unique flavors such as residential, retail, health care or mortgage exposure. The largest U.S. and international REIT ETFs are listed below.

A unique shareholder friendly benefit of REITs for income seekers is their legally required profit distribution — REITs dispense at least 90% of their taxable income to shareholders, a figure closer to 30%-50% for most dividend stocks. As they also own physical assets such as malls or housing complexes, and generate income based on rental fees or occupancy fees, they are arguably more stable as well. After all, it’s hard to argue the essential nature of hospitals, nursing facilities, retirement homes and the like.

Symbol Description 12-month yield Standard deviation (5-year) Returns (5-year annualized)
VNQ Vanguard US REIT 3.76% 15.97% 14.91%
VNQI Vanguard International REIT 3.85% 13.04% (3 year) 13.85% (3 year)
IYR iShares US Real Estate 3.59% 14.95% 13.45%
RWX SPRD International Real Estate 3.05% 16.10% 12.54%
With yields around 3%-4%, double bond rates, and unique diversification in terms of physical businesses, REITs show promise. However, they also have high volatility with standard deviations comparable to equities, though their five-year annualized returns are surprisingly impressive. Overall, it provides a nice intermediary choice between bonds, stocks and preferred shares.

There are other potential income-like assets beyond dividends, REITs, and preferred shares but these generally represent the most liquid and well regarded among them. While bonds will eventually drop in price and rise in yield over the next few years, holding them through that process will be challenging considering the low reward. These options may be a reasonable place to hide in the interim until the bond market settles.

[“source-marketwatch.com”]