People often ask about income investing. My contrarian opinion is that sometimes it is better to meekly accept a low yield from a low risk high quality bond mutual fund rather than chase after high yielding junk bond types of investments. If someone needs more cash flow than a low yield allows then they will simply have to sell off and spend down a sliver of principal each year until the economy returns to normal and rates go up and default risk (hopefully) goes down.
Senior citizen’s first priority is to avoid excessive risk so that means avoid things that are similar to junk bonds. Buying high yielding stocks is risky because the stock could be going through the “value trap” and its price could drop drastically with a permanent loss of principal. The only reasonable choices are bond funds paying no more than 5% but they need to be diversified with more conservative funds paying 2.9%.
Life is unfair. Currently retirees are having their savings drafted into Bernanke’s army and paid less than the "minimum wage", (just as soldiers can be drafted out of a good paying civilian job and then paid a nominal salary in the Army) which is my analogy about the Fed’s actions to push rates down to absurdly low levels.
A bond expert said in a speech that junk bonds actually produce a total return that is lower than “A” paper bonds because of losses to principal from defaults.
I am shocked at the opinion offered by many advisors that since some stocks yield over 3% then they say “why not buy stocks instead of bonds because they yield more than bonds”. The problem is that stocks are overpriced and could easily drop 30% or even 50%, while bonds (though they have inflation and currency devaluation risk) are far less risky than stocks.
Avoid these interesting but risky investmentsSome interesting high yield stocks to avoid are some mortgage REITs that yield in the mid-teens. They borrow at the Fed funds rate of under 1% and invest in mortgages yielding 3% and lever up the 2% profit by a factor of 8 thus producing a yield of mid-teens. But this is extremely risky because if interest rates rise then they will have no profit and the mortgages they own will drop in value resulting in losses that will probably be permanent. This would trigger mass panic selling of the stock and the shares would drop significantly in value.
Avoid closed end funds that increase payouts by paying a dividend that includes some of the amortization of principal that comes from a maturing loan portfolio. This type of dividend yield is really part of the shareholder’s principal (which is not the same as earnings). It is misleading and causes investors to accidentally, unknowingly spend down part of their principal. If they want to spend down principal it should be part of a clear, explicit plan.
Another misunderstanding that creates the appearance of reliable, recurring income is when a bond mutual fund makes clever trades by buying distressed, defaulted loans at fire sale prices and then selling them off at a profit after the loans improve. Unfortunately, while this is a commendable act by the fund companies, it is a one trick pony because eventually all the loans that can be salvaged and sold at reasonable prices will have been sold and then this source of extra income will end in a few years. Because the income stream has lasted for more than a year and it is income and not cash flow from amortization of principal then this is theoretically income that a retiree could spend but unfortunately it is not sustainable income, instead it is a temporary surge in income due to the cleanup of the mortgage mess. Further those operations incur risk that foreclosures could get worse causing unexpected losses to those mutual funds.