Stash cash carefully to yield significant investment income

October 1, 2010

If you depend on some of your investment portfolio to produce income, you’re suffering from a bad case of sticker shock. Let’s see what an investor with the tidy sum of $100,000 to invest might get for his money at today’s anemic interest rates.

If you depend on some of your investment portfolio to produce income, you’re suffering from a bad case of sticker shock. Let’s see what an investor with the tidy sum of $100,000 to invest might get for his money at today’s anemic interest rates.

The ultra-conservative investor might look first to a bank Certificate of Deposit (CD) with the principal guaranteed by FDIC insurance. At current rates, a one-year CD would produce an annual income of $1,500 or so. If that investor was willing to lock her money up tight with a five-year CD, she could look forward to annual income of about $2,100; an additional $600 per year with no way to get her money back without an early withdrawal penalty.

How about a money market account? Can we do better there? Money market accounts are good places to stash cash that you might need to withdraw at any time without a penalty.

Sorry. At today’s average annual percentage yield (APY) of less than 1 percent, a money market account makes CDs look like a good investment. For your investment of $100,000, you’ll be lucky to get an average annual income of about $750 - not enough for a weekly dinner out at a local diner.

Bond benefits, drawbacks
With treasury bonds, an investor looking for income can do a little better. A five-year treasury is paying about $2,290 per-year. With a 10-year commitment, that jumps up all the way to $3,430 - the best so far. But hold on. Bonds, like stocks, can go up and down in market price. That means that if you need to cash in before maturity, you could suffer a loss in principal.

What about corporate bonds? Can the investor looking for income do any better in that arena? Well, yes and no. A reasonably safe corporate bond can provide a return of as much as double that of the above figures. However, it’s important to remember that corporate bonds are arguably the riskiest of all fixed income investments.

There are two agencies that assign credit ratings to corporate bonds based on the company's ability to repay its debts: Standard & Poor's and Moody's. While these companies have enjoyed a good reputation over the years, both came under attack during the recent recession for doing what some felt was an inadequate job assessing things such as corporate debt instruments.

When you buy a corporate bond, you're lending money to the company. In return, you receive fixed interest payments until the bond matures, at which time your principal is returned in full, provided the company has maintained a healthy balance sheet and avoided default. While defaults on well-rated corporations are relatively rare, they can and do happen.

However, corporate bonds do provide some protection; bondholders get higher priority than people who own common stock of the same company. If the company goes bankrupt, bondholders are paid ahead of stockholders.

Preferred stocks pay off
So, what’s left for the investor looking for income without foraging around in so-called junk? Among several often-overlooked possibilities are assets that look like stocks, behave like bonds, but pay better interest rates than either. They’re called preferred stocks, and they account for only about 1 percent of the total value of all common stocks. Why do these investments get less respect than Rodney Dangerfield? Possibly because they aren’t well understood.

Preferred stocks are so named because they get preferred treatment over common stocks in two important ways. First, companies with preferred stocks outstanding must pay their preferred dividends before they can issue dividends on their common stock. This injects a degree of comfort for investors relying on a continuing stream of dividends. Second, if the company goes under and its assets must be liquidated, preferred stockholders must be paid from those assets before common stockholders. However, first in line for getting paid off are bondholders. That’s the main reason why preferred stocks tend to pay higher rates than bonds from the same or similar companies.

Another advantage of preferred shares is that some companies, but not all, give their preferred stockholders the right to convert their shares into common stock at a prearranged price.

As is the case with common stock dividends, a company may decide it no longer wants to pay the preferred dividend. Here again, preferred stockholders have an advantage. If a company stops paying its preferred dividend, it still has an obligation; it must repay all the money it would have paid to preferred shareholders before it can pay any dividend to common stockholders.

If preferred stocks with their higher income potential sound attractive, (several high-quality companies are now paying 7 percent or higher yields on their preferred stock), one way to spread your risk would be to buy a mutual fund that consists of an assortment of preferred stocks from a variety of companies. One such fund is iShares S&P U.S. Preferred Stock Index Fund (NYSE PFF) currently yielding more than 7 percent. Another is SPDR Wells Fargo Preferred Stock (NYSE PSK) with a similar return.

Do your homework
There’s no way to get around it. Today’s paltry interest rates make for a difficult investment climate for savers who are looking more for steady income than for the possibility of capital gains.

As is the case for all savings and investment possibilities, doing your homework and learning as much as you can about your choices between degree of risk and dependable income is more important than ever.