Tuesday, January 31, 2012

Income Ideas

With interest rates offered by banks near zero and rates on U.S. Government securities not much higher than that, where can investors generate investment income?

I previously have recommended stocks with high dividend yields and dividend growth prospects.  The current era is quite extraordinary, as dividend yields on the S & P 500 exceeds the yield on U.S. government notes for the first time since the 1950's.  With the 20% rebound in the S & P 500 since October, however, I'd recommend waiting for a correction before buying many stocks.

But there are two alternatives that I currently like.  I still think that high-yield bonds are attractive, and yields of 7-8% are available.  Unfortunately, the interest is taxed at ordinary income rates, so they are most appropriate for tax-deferred accounts (unless the investor is in a low tax bracket).

In addition, there are selective opportunities in preferred stocks, which typically are issued by banks.  While I am cautious about common stocks of banks, dividend yields of 7-8% are available on straight preferred shares.  Some preferred dividends are tax at 15%, others are not and are taxed at ordinary income rates, so one should choose carefully.

This week I bought two preferreds with yields of almost 8% and which have qualifying dividends (taxed at 15%).  If economic conditions deteriorate significantly, banks would likely cut common dividends first, giving the preferreds one level of safety.  

In addition to the tax rate on the dividends of preferred stock, another consideration is the call provision.  Most preferred stock can be called in by the issuing company after a specified date, and the call price often is below the current market price, so a holder could face a capital loss.  The two stocks that I bought this week do not face an imminent risk of being called on unfavorable terms.

Those are two ways of generating high investment income at a time of low interest rates, and if the stock market declines--which I think is increasingly probable--there will be a number of common shares with good dividend yields.  

Steve Lehman

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