3 investments to endure 3 more years of low rates

[September 24, 2012]  BOSTON (AP) -- Risk-averse investors, prepare to be disappointed a good while longer.

Expect interest rates to remain low at least three more years, with investments earning very little unless you're willing to accept plenty of risk. Money-market mutual funds are likely to continue paying barely above zero, with 10-year U.S. Treasurys yielding less than 2 percent.

That's the outlook after the Federal Reserve's latest move to stimulate the economy by prodding Americans to spend and borrow more, and invest in stocks again. The program announced last week has been dubbed QE3 -- a third round of what economists call quantitative easing, aimed at helping a slow recovery gain momentum.

This program goes further than previous ones. The Fed made an open-ended commitment to buy $40 billion of mortgage securities per month until the job market improves "substantially." The central bank also extended its pledge to keep short-term interest rates super-low at least into mid-2015. That's six months longer than the Fed had previously planned.

Stocks have risen almost 2 percent since the Fed's Sept. 13 announcement, in part because the program went further than investors had expected. It was "the unveiling of a monetary bazooka," says Wasif Latif, vice president of equity investments at mutual fund manager USAA Investments.

Chairman Ben Bernanke made it clear after the announcement that the Fed's bond-buying is intended in part to lift stock prices. Stock gains increase Americans' wealth, he noted, which makes people and businesses more likely to spend and invest more.

Yet reluctance to invest in stocks, a likely source of frustration for Bernanke, has been a hallmark of a market recovery that's been under way three and a half years. Stock prices have doubled from the market's low in March 2009, but Americans are still withdrawing cash from stock mutual funds in favor of less risky options.

The latest evidence: Stocks rose 7 percent from June through August. Yet investors pulled cash from stock mutual funds each month -- $24 billion in net withdrawals, according to industry consultant Strategic Insight. Some of that cash went into bond funds, which offer less potential for sharp gains or losses. Indeed, bond funds have attracted cash for 12 consecutive months.

The movement of cash illustrates how nervous investors are about market volatility and the economy four years after the financial crisis.

"Stock investors remain in a holding pattern, with many watching the rising stock prices with regret or disbelief," says Avi Nachmany, research director with Strategic Insight.

That cautious mindset is one reason Latif doesn't expect the Fed's latest move will be enough to get average investors to return to stocks.

"You need to have sustainable stability, both in the economy and in the markets, for the traditional long-term investor to get back in," says Latif, a co-manager of asset allocation funds at USAA Investments that invest in stocks and bonds. "And that is not necessarily going to happen overnight."

He notes that the stable returns that most bonds generate are likely to continue to appeal to the growing ranks of risk-averse investors. Many are retired, and rely on investment income to help cover living expenses. They worry about the possibility of another sharp decline in stock prices.

If that describes your current attitude about investment risk, but you're also looking to generate income, here are three relatively low-risk investment options to consider in this low-rate environment:

1. DIVIDEND STOCKS

Invest in dividend-paying stocks or funds that specialize in them, and you can expect steady income, along with potential gains from rising stock prices. Dividend-payers tend to rise more slowly during market rallies, but suffer smaller losses when stocks decline. So if a market downturn is around the corner, dividends will offer some protection. Just remember that companies often cut dividends when the economy skids, as they did in large numbers to conserve cash after the 2008 market meltdown.

Still, many investors are finding the potential returns and income worth the risks. Investors deposited a net $22.5 billion into dividend-stock funds -- usually labeled `equity income' funds -- over the 12-month period through August, according to Strategic Insight. During that period, a net total of $114 billion was withdrawn from all other stock fund categories.

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 return of 15 percent over the latest 12-month period, according to Morningstar. That's the best performance among all bond fund categories, and only slightly lower than the average returns for most categories of diversified stock funds.

High-yield bonds are typically less volatile than stocks, but they're a high-risk option relative to other bonds. Current risks include the possibility that Europe's debt problems will 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 issued by 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. Those tax breaks can be especially important for those in higher income brackets.

Munis have been strong performers recently. Returns have averaged of 6.4 percent over the last 12 months for funds investing in intermediate-term munis, according to Morningstar. That's roughly double the return that funds investing in intermediate-term U.S. government debt have posted.

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. Risks include a setback for the economic recovery, which could put more pressure on government budgets, possibly leading to a jump in defaults. Any rise in interest rates also could crimp bond returns.

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[Associated Press; By MARK JEWELL]

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