Dos and don’ts for income investors
This is a difficult environment for individuals living on a fixed income. The problem is trying to invest money safely while getting a reasonable return on an investment (ROI). Money market funds and CDs are barely even keeping up with inflation.
Longer-term bonds pay higher interest rates, but longer-term bonds might be more dangerous to own. (Note: At the end of 2017, the US Fed's rate-setting Federal Open Market Committee decided to increase US benchmark interest rates by a quarter-point, setting the target range between 1.25 percent and 1.5 percent ...what financial markets had previously expected.)
However, here are my best suggestions for fixed income investors.
1. Short-term bonds. A diversified portfolio of short-term bonds or for investors in a high tax bracket, short-term municipal bonds. Short-term bonds pay higher interest rates than money markets or CDs and in addition, they will typically lose very little principal relative to longer-term bonds should interest rates go up.
2. Fixed annuities. Fixed annuities currently guarantee a minimum return of 2.5-3.5 percent and the income is tax-deferred, which makes them even more valuable for taxable investment accounts. It is also important to realize that fixed annuities won’t lose principal should interest rates go up.
3. Dividend-paying, large U.S. corporations. High quality, large multi-national U.S. corporations that have provided consistent increases in dividends for 10-20 consecutive years. For example, look at the S&P Aristocrats Index or the ETFs that represent this index. These stocks are very large and they dominate their markets. These companies are not going bankrupt; they will be around a long time and a diversified portfolio paying out 2-3 percent in dividends annually will go a long way in supplementing the lower income received on fixed income investments. Not to mention, you will get long-term growth and you can wait a long time for market corrections to recover when your stock portfolio is consistently providing dividends of 2-3 percent annually.
1. Long-term or intermediate-term bonds. Stick with short-term bonds (less than 3-year durations). Longer-term bonds will lose too much principal when interest rates go up.
2. Balanced funds. These funds hold 40 to 60 percent bonds with average maturities of 8 to 12 years. Therefore, half of the investments in these funds will lose money as interest rates go higher.
3. Target date funds. These funds are very misunderstood by investors. They are marketed as an investment that will automatically be adjusted for investors to be less and less risky as the investor gets closer to retirement. The problem is to make the funds less risky they invest more of the fund’s portfolio into bonds (8- to 12-year maturity). In an environment where the Fed intends to raise interest rates these funds are actually becoming riskier the closer investors get to retirement.
It may be difficult for fixed income investors to find safe income but, remember that we also have very low inflation right now. Therefore, it’s not necessary to get 5-6 percent interest on your fixed income investments when inflation is less than 1 percent. If you’re living on a fixed income, it is important to maintain the purchasing power of your savings. However, getting a 3 percent return, when inflation is 1 percent, is the same as getting 6 percent when inflation is 4 percent, at least as it relates to purchasing power!