By Philip van Doorn, MarketWatch
The seesawing stock market may finally prompt investors to dedicate more money toward high-dividend-paying companies, bonds and real estate investment trusts.
After all, some form of income strategy is better for many long-term investors, even those who aren’t retired or close to retirement.
There certainly is an urgency for safer investing, as there may be more trouble ahead for stocks. For one, companies have lowered earnings estimates for the second half of the year. And a range of other worries — China’s slowing economy, rising official interest rates by the Federal Reserve — are weighing on investors’ minds. On Wednesday, the S&P 500 Index /zigman2/quotes/210599714/realtime SPX -0.72% rallied 3.9%, the biggest gain in four years, putting an end to an 11% decline in the six days through Tuesday. Stocks rose again in early trading Thursday.
Among the benchmark S&P 500, 486 companies had reported earnings results for the most recent quarter (through Tuesday). While many sectors posted impressive earnings-per-share growth, most are lower than they were a year earlier. And the pace of profit growth for the second half of the year may slow considerably, based on companies’ lowering of guidance.
Here are the S&P 500’s 10 sectors sorted by EPS growth rates for the most recent quarter:
|S&P 500 sector||Second-quarter EPS growth rate||Year-earlier EPS growth rate|
|Source: S&P Capital IQ|
The energy sector is dragging down the index, and seven of 10 sectors are showing slower EPS growth.
How much have you been affected by the equity market turmoil over the past week? For many long-term investors, it hasn’t really been a problem because they expect history to repeat itself with a recovery for stocks. Or they may rest easy because they know that during a down market, contributions to 401(k) or similar retirement plans that are invested in stock mutual funds will be going in at lower prices. That can be a very good thing if you have an investment horizon that stretches for decades.
But do you worry every day? If so, maybe you should focus some or even most of your investment efforts on income rather than growth. A constant stream of investment income can make it much easier to sleep at night. With enough income, you can fund new investments to generate even more income and grow your pot of gold in a lower-risk way than you would with a stock portfolio. Your returns over long periods are likely to be lower, but you may rest easier.
The income approach may not be for everyone. Most long-term investors are likely to be better off in broad index funds, assuming that events such as those we have seen over the past week will not cause them to sell in a down market.
Even with an income approach, there will still be volatility. If you invest in a bond fund, you might get a decent yield and enjoy the monthly dividend payments, but you will also be dealing with fluctuating share prices. Market prices for bonds decline when interest rates rise, and short-term rates in the U.S. have been near zero since late 2008. The Federal Reserve is expected to begin raising short-term rates this year. While we cannot say how rapidly long-term interest rates will rise, it does seem that prices for long-term bond funds will be declining. And there’s no guarantee that your losses in a bond fund will be made up when rates fall again.
You can focus on bond funds with shorter durations (and lower yields) to limit volatility risk. Then, if you are willing to take more credit risk, you can consider high-yield, or non-investment-grade (“junk”) bond funds. One example in that category is the RiverPark Strategic Income Fund /zigman2/quotes/201160047/realtime RSIVX +0.34% , which we reviewed in July.
But there’s more you can do to worry less about volatility.
Hold your own paper
If you own your own bonds, you can avoid the daily stress of fluctuating share prices — and also mutual fund management fees. That assumes the bonds don’t default, of course.
If a bond was issued when interest rates were higher than they are now, you may be paying a premium to buy it, which will lower your yield to maturity. Your broker can help you make the appropriate calculations to make a decision.
For example, if a bond with a face value of $10,000 is trading at a 5% premium, you will pay $10,500 for the bond and only receive $10,000 when the bond matures. You might find that the yield is high enough to make it worth taking that loss.
You might also be able to buy newly issued bonds at par value through your broker.
Whether you pay par, a premium or a discounted price, you will eventually be repaid the face value, no matter how much the market value of the security fluctuates each day. By holding the bond until maturity, you will not be tempted or burdened by daily price quotes.
Depending on your marginal tax rate and how high your state income taxes are, you may also find municipal bonds worth a look, since they are exempt from federal income taxes and from state and local taxes, if the bond was issued in your state.
Of course, bond rates are pretty low. The yield to maturity for the Bank of America Merrill Lynch U.S. Corporate Bond Index is 3.45%.
With bond rates so low for so long, you might need to be more aggressive when considering higher-yielding asset classes.
Preferred stocks are different from common stocks in that shareholders have no voting rights. But preferred stocks have a stated dividend rate, with a par value, just like bonds. Many also have call dates. A call date is similar to a maturity date, except that the issuer has the option of buying back the stock at that time.
Just as you would for a bond, you need to calculate the market yield for a preferred stock you are considering.
For example, J.P. Morgan Chase & Co. /zigman2/quotes/205971034/composite JPM -1.79% non-cumulative perpetual preferred series Y shares trade under the ticker JPM-F, have a $25 par value, a dividend rate of 6.13% and a call date of March 2, 2020. The shares traded for a discount, having closed at $24.84 on Tuesday. Non-cumulative means if the company suspends the dividend, and then resumes paying, it will not have to make up any dividend payments that were missed.
The annual dividend payments on this preferred stock total $1.53125 a share, so the current yield, based on Tuesday’s closing price, is 6.16%. The yield to call, which reflects the current discount and the fact that you will be paid the face value of the shares if the company redeems the stock, is 6.29%.
When you buy preferred shares in the open market, you pay a commission to your broker (which you might be able to negotiate lower, if you have a full-service broker), and pay a premium or get the shares for a discount. But you may also have the opportunity to buy newly issued preferred shares “off the shelf,” with no commission, if your broker participates in the underwriting. Talk to your broker.
QuantumOnline is an excellent source for lists of preferred stocks.
(Please read on for a discussion of three other classes of income securities.)