Make Mr. Market Work for You

 | Aug 17, 2011 | 2:59 PM EDT
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I spent some time last night thinking about the implications of the recent Fed interest-rate announcement. To the best of my knowledge, a pledge to keep interest rates low is unprecedented and has serious consequences for investors. The exceptionally low short-term rates have been a burden on those who need income to fund retirement and I am curious as to why more retired folks are not protesting loudly. I am surprised that the Association of American Retired Persons (AARP) and other senior organizations have not organized rallies and marches to beat down the doors demanding higher rates for their savings.

Think about those who retired in 2001. Using conventional wisdom, these unlucky individuals mixed up some 10-year Treasuries, maybe a laddered portfolio of certificates of deposit (CDs), some high quality corporate bonds and maybe some index funds to give them exposure to the inflation-protecting nature of equity ownership. They should have been able to earn a blended rate of a little north of 6% on the whole package. Let's say our retirees were pretty thrifty and that each had a combined $1 million to invest for retirement income. They could collect roughly $60,000 a year off the package. Not bad when you add in a little social security check. Today as all this stuff comes due they are reinvesting at ridiculously low rates and would see their income fall by well over half. Worst of all, their equity portion has done absolutely nothing as prices for food, clothing and everything else has skyrocketed over the last decade. It is an ugly picture.

For the next two years at least, I am starting to see some solutions for those who need income. I think that low rates on the short end put mortgage real-estate investment trusts (REITs) in the sweet spot. Even if the curve should invert here from future easing programs, making it difficult to invest, new funds the bonds currently hold in the portfolio will soar in value. In the meantime, securities such as Invesco Mortgage (IVR) and Annaly Capital (NLY) are trading near or below net asset value and offer generous dividend yields. I think a package of several of these, including REITs such as Chimera (CIM), American Agency Capital (AGNC), and Hatteras Financial (HFS) would make nice additions to an income-hungry portfolio.

There is no need to get excessive with your allocation to mortgage REITs. An allocation of as little as 10% of these high-yielding securities can have a significant impact on an income portfolio. Combined with an allocation to a carefully selected portfolio of high-dividend paying stocks, investors may not be able to entirely replace the old income stream, but they can reduce the pains to a small degree.

Closed-end municipal bond funds that use leverage may also benefit from artificially maintaining low short-term rates. They borrow using adjustable-rate preferred stocks or other short-term funding mechanisms to pay out a higher yield. A flat yield curve would potentially reduce payouts, and an inversion of the curve would be devastating for these funds. Given the Fed's desire to keep the short end at almost 0%, I do not see inversion as a real threat for the next two years. I am finally seeing some of these funds trade at a respectable discount to net asset value, and they could be a valuable addition to a taxable income investor's portfolio

Investors need to use a little common sense when buying these funds. Only buy funds trading below net asset value (NAV). Avoid single-state funds in troubled areas such as California or Michigan unless you are speculating on a recovery in those states. Invest on days when there are rumors and discussions of troubles in the muni markets and the shares sell off a little. Do not fall in love with them. If long rates fall sharply, sell them at a profit and move on.

This is an incredibly difficult time for income investors. The traditional safe choices are no longer adequate to meet most peoples income needs. You are forced to turn to alternatives such as stocks, REITs and even corporate or municipal bonds. There is no longer a "set and forget it" retirement income plan available. By focusing on valuation and making Mr. Market work for you by buying during market downturns, you can assemble a reasonable income portfolio. It is just a lot harder than it used to be and requires a lot of patience and discipline.

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