3 investments for an era of low interest rates

[February 03, 2012]  BOSTON (AP) -- The Federal Reserve is making it increasingly hard for investors to earn anything, unless they're willing to accept plenty of risk. Ben Bernanke and his Fed are playing the role of adviser, encouraging Americans to get a little more adventurous by shifting savings out of low-yielding bonds and putting it to work in stocks.

The latest nudge came last week when the Fed said it doesn't expect to raise its benchmark rate until late 2014, at the earliest, because the economic recovery remains fragile. Rates have been near zero since December 2008. The latest extension means borrowers can expect another three years of low-cost loans and mortgages.

However, it's more bad news for savers and retirees depending on investment income, particularly when there's 3 percent inflation. Investors who value earning stable returns from Treasury bonds end up with little more than satisfaction that they're faring better than people keeping money in traditional savings accounts.

Consider that investors committing to lock up their money for a full decade were only being paid 1.8 percent for buying U.S. Treasurys this week. And yields have turned negative for investors trading 10-year Treasury Inflation-Protected Securities, or TIPS. On Wednesday, the yield was negative 0.28 percent. In essence, investors are willing to pay Uncle Sam to borrow their dollars for 10 years, because the opportunity to minimize losses is attractive compared with other options.

That may be patriotic if the government puts that borrowed cash to work to stimulate the economy. But it's no way to invest for your future.

"I don't know why people would pay the U.S. government to borrow their money, unless they're very, very pessimistic," says Robert Horrocks, chief investment officer and a portfolio manager with the Matthews Asia mutual funds.

Returns are even smaller for money-market funds, safe harbors where investors can park their cash until they're ready to put it back into the market. Money fund returns are closely tied to interest rates, and their returns have been barely above zero for three years. They're now averaging 0.02 percent -- call it nothing. Don't expect improvement until the Fed pushes rates back up.

Here's a look at three relatively low-risk alternatives to generate some income in a low interest rate environment:

1. Dividend stocks

Dick Bristol, a 74-year-old retired Air Force major from Biloxi, Miss., counts on dividend-paying stocks for his retirement security. His investment portfolio is nearly 100 percent in stocks that make regular payouts, and he and his wife count on a few hundred dollars of dividends coming in each month.

Of course, dividend-paying stocks are not immune from market drops. And companies often cut dividends when the economy skids. But Bristol is convinced the potential returns are worth the risks. In August, he invested in Dynex Capital, a real estate investment trust. The stock has since risen 8 percent and has a high dividend yield of 12 percent. That's the amount of the dividend paid divided by the share price.

"Keep in mind that if you invest in something that's earning 1 to 2 percent, you're losing out to the 3 inflation we've got now," Bristol says. "Over the long run, nothing pays like dividend stocks."

2. High-yield bonds

These bonds are issued by companies with credit problems. High-yield investors expect higher returns because there's a greater risk of default than with companies possessing investment-grade ratings. And they've gotten them recently. Mutual funds specializing in high-yield bonds have produced an average annualized return of 19 percent over the last 3-years.

Anne Lester, lead manager of JPMorgan Income Builder (JNBAX), has recently been adding to the fund's holdings in high-yield bonds. They now make up 44 percent of a portfolio that also is invested in stocks. Corporate default rates remain low and high-yields are attractively priced compared with Treasurys and other bonds, Lester says.

The market is pricing high-yield bonds "as if we were in a recession, and we're clearly not in one," she says.

But high-yield bond investors face plenty of risks. Chief among them is the possibility that Europe's debt problems spin out of control. That could put the domestic economic recovery at risk, potentially leading to a spike in corporate defaults and losses for high-yield investors.

3. Municipal bonds

Investments in the bonds of state and local governments typically won't make you rich, because returns are generally low. But muni bond interest payments are exempt from federal taxes. That protection may extend to state taxes if the munis are issued by the state in which the investor lives. Investors can pocket attractive returns even after taxes, because the tax hit can be sizeable for those in higher income brackets.

Muni bond funds have been on a terrific run, with average returns of nearly 15 percent over the last 12 months. But don't expect double-digit returns this year. Muni bond prices have rebounded from a market scare in late 2010, when the poor financial condition of many states and cities left investors nervous about a surge of defaults. Although many governments remain troubled, there has been no default surge and municipal bankruptcies declined last year, says Jim Colby, a muni bond analyst with Van Eck Associates.

A setback for the economic recovery could put more pressure on government budgets. But Colby says munis remain an attractive alternative to Treasurys. He's expecting muni returns to average 4 to 5 percent over the next few years.

"Munis give an investor opportunity," he says, "at a time when so many are saying, `Boy, I'm having a hard time stomaching these low Treasury yields.'"

[Associated Press; By MARK JEWELL]

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