Income Investors Feel the Squeeze

Lewis Thayer grew frustrated over the last year by the low returns he was earning on certificates of deposit at his bank. So the Media retiree began temporarily parking his money in a savings account.

Thayer is still weighing his next move.

"Whatever income I'm getting, it's from money sitting in a bank," he said. "I know it's not good. I've got to do something to bring it up."

The Dow Jones industrial average may be flirting with 10,000 again after a seven-month rally, but the drought continues for income investors, leaving folks who depend on interest checks from bank investments or bonds to choose one of three risks in an attempt to wring a better return in a low-interest climate.

Retirees must accept subpar earnings, or chase higher yields by tying up their money long-term or by buying risky investments, putting their principal at risk in the process.

Experts counsel investors to bide their time, even if it means giving up some income for now.

"There's a good chance in the next year or two that interest rates will be significantly higher than they are now," said David R. Kotok, chairman of Cumberland Advisors, of Vineland, N.J.

For retirees who cannot wait, experts suggest investing in securities, such as municipal bonds or mortgage-backed securities, that are less vulnerable to the other perils.

Thayer, 76, cannot afford to be patient. Prices keep climbing even if CD rates do not. Inflation rose 2.3 percent in the last 12 months, according to the U.S. Bureau of Labor Statistics, or roughly twice the average, one-year CD rate of 1.08 percent in last week's surveys by Bankrate.com.

The price increase measured by the Consumer Price Index understates the impact of inflation on retirement budgets because health-care costs, a major expense for older Americans, are rising at double-digit rates.

To overcome inflationary risk, investors can choose higher-paying, long-term securities, such as annuities. Of course, those rates are now also low by historic standards.

"I know what it is like for someone to lock in a 4 percent rate," said Hersh Stern, publisher of the Annuity Shopper and WebAnnuities.com, which specialize in immediate annuities. "It stinks."

Annuities are crosses between investments and insurance. In an immediate annuity, an investor pays a lump sum in exchange for an immediate stream of monthly checks that the insurer promises will last for the rest of an investor's life.

Like the traditional pensions they resemble, annuities can be structured to pay income to a surviving spouse for life, or to cover a specific number of years.

Warren Buffett's Berkshire Hathaway Group is quoting monthly income of $669 for a 65-year-old male with $100,000 to invest - the equivalent of 4.7 percent given Berkshire's estimates of normal life spans.

While the rate is not overwhelming, annuities at least dodge what is known as interest-rate risk - the capital losses that hit existing securities when interest rates rise. This is the second risk for income investors.

Let's say an investor has a $1,000 bond paying 3 percent. If market rates rise so new bonds pay 4 percent, no one will pay the full $1,000 for the 3 percent bond. For the bond and its $30 annual interest payment to equal the market return on new bonds, a buyer would pay just $750 - a $250 loss for the seller.

GNMA bond funds, which hold government-insured mortgage securities, are an exception. Homeowners refinance when rates drop and stay put when rates rise, dampening the reaction of GNMA funds to interest-rate changes.

The Blackrock GNMA fund yields 4.6 percent now, said Rajiv Sobti, comanager of the mutual fund. "In the short-term, there will be some concern" that the yield will lag if homeowners refinance their mortgages in smaller numbers.

The share price of the Blackrock GNMA fund fell 1.9 percent in July after interest rates jumped in July - but that compared with a 3.4 percent loss for the Lehman Bros. aggregate bond index, a broad measure of bond performance.

These are only paper losses as long as investors remain patient and do not sell. Bond issuers repay the face value when the security comes due, regardless of how market rates have changed.

But patience will not help investors who own bond mutual funds if fellow shareholders abandon ship en masse. Bond funds sell securities to meet redemptions, locking in those capital losses.

Bond fund investors bailed in record numbers in August, according to Lipper Inc., pulling $15.3 billion out of short-term funds and long-term ones alike.

Bond investors have a history of selling at the bottom. The previous record outflow from bond funds, in November 1994, marked the bottom of the worst year for bonds in modern history.

"The U.S. is not a bond culture," said Andrew Clark, a Lipper senior analyst.

Investors who like the diversification of mutual funds should consider exchange-traded funds as a way to shield their holdings from capital losses.

Exchange-traded funds are a form of mutual fund traded on stock exchanges. Bond ETF prices also fall as interest rates rise; but because they are bought and sold like stocks, sponsors are not forced to liquidate holdings to meet redemptions and thus avoid locking in losses as mutual funds do.

Barclay Global Investors' iShares Goldman Sachs InvesTOP Corporate Bond Fund yielded 5.1 percent recently, according to Bloomberg.

ETFs buy and sell securities over time to keep pace with the indexes they track, said Matt Tucker, a Barclays investment strategist. Even so, longer-term bond funds "are pretty consistent," he said.

Meanwhile, municipal bonds' interest rates have held up better than those on other kinds of bonds, said David Baldt, an executive vice president in Philadelphia for Schroder Investment Management North America.

"Munis are bought by retail customers rather than big institutional customers," Baldt said. Because individual investors shun low rates, muni issuers must offer more.

The average performance of the national short-term municipal bond funds tracked by Morningstar, at 1.79 percent, trounced Treasury bond fund averages at all maturities, plus short-term corporate funds.

Moreover, muni bond funds get preferential tax treatment. Interest on municipal bonds is not subject to federal income tax, or to state income tax if the fund restricts its holdings to the state in which the investor lives.

Do not be dazzled by state tax savings, Baldt said. "Look beyond Pennsylvania," he said.

Be mindful of the third risk - that the issuer will default - and an investor's principal will be lost.

"Don't change your risk profile to get higher income," Baldt said.

PNC Bank was offering 0.35 percent recently on a one-year CD according to Bankrate.com. It is possible to find borrowers paying 30 times as much, but there is a reason for high rates.

What investors do not know about these offers can hurt them plenty.

Source: philly.com - 10-28-2003