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For income investors, it’s all about risk

As published 4/9/15 in the

Minneapolis Star Tribune:

It’s definitely more complicated than it’s ever been,” said Tim Palmer, managing director at Minneapolis-based Nuveen Investments. Palmer was describing the quandary income-hungry investors face in the current unprecedented six-year run of historically low interest rates.

For much of the past 25 years, investors could purchase highly liquid risk-free U.S. government securities and count on positive real returns while generating current income. But since the Federal Reserve dropped its key overnight federal funds rate to near zero at the depths of the Great Recession and held it there, retirees and other investors who rely on their portfolios for interest and dividend income have struggled in their search for yield.

“Risk-free is now priced like risk-free,” Palmer said, meaning income-seeking investors need to look beyond U.S. treasuries. Palmer, who manages the $1.1 billion Strategic Income Fund, uses words like “nimble,” “flexible” and “opportunistic” in describing the appropriate investment approach, saying investors need to “take some risk.”

But investors also need to be aware of the kinds of risks they are taking on.

Most fixed-income investors think about three kinds of risk. The first is the risk that a corporation or government will default and stop paying interest on its debt. That’s easy enough to understand, but hard to predict, which is why “junk bonds” viewed as more risky than AAA-rated debt pay a higher coupon.

The second kind of risk, interest rate risk, is more complicated. In the world of fixed income investing, bond prices have an inverse relationship to interest rates, which means when interest rates rise, the price of the underlying bond falls. As the market anticipates the Fed beginning to loosen interest rates later this year, interest rate risk enters into investor thinking as well.

Currency risk is important for investors holding international debt, highlighted by the recent rapid rise of the dollar against major global currencies.

Palmer’s approach to fixed income investing is to spread risk across multiple classes of debt securities. Palmer is diversifying into both high-quality and high-yield corporate debt, as well as international debt and some preferred stocks that are a hybrid of debt and equity securities.

Some of his largest holdings include high-quality corporate debt from Goldman Sachs and Bank of America. In addition, he holds government debt from South Africa and Mexico but said he is avoiding Brazil, Australia and New Zealand while “walking the tightrope” managing currency risk.

Ninety percent of a fixed-income investor’s return comes from income not principal, Palmer pointed out, so if investors do their homework they should not get overly concerned “about every little wiggle in Fed policy.”

Ben Marks, founder and CEO at Minnetonka-based Marks Group Wealth Management, is taking a different approach to help his clients reach their income goals. Marks thinks the risks of reaching for yield in fixed-income instruments are “underappreciated by investors.” Locking into long-duration bonds or preferred stocks increases exposure to interest-rate risk while taking positions in high-yield junk bonds increases credit or default risk, he said.

He thinks the U.S. economic recovery will continue and the global economy will follow, creating upward pressure on interest rates. Urged by a client to develop a less risky approach to generating income in that environment, Marks, whose firm manages $650 million in assets, launched an equity income offering in January.

Instead of looking for income from debt securities, Marks focuses on investing in common stocks paying high dividends. While cautioning that stocks with a high dividend yield are subject to some interest rate risk, Marks seeks to offset that by focusing on companies whose underlying businesses, and stock, are likely to do well as interest rates rise with an improving economy.

Constructing a portfolio of stocks with a high current yield will naturally tend to concentrate on a few sectors, he said.

Marks avoids traditional high-yielding stocks such as electric utilities and tobacco companies because their underlying businesses are not as likely to benefit from an improving economy. Those stocks “tend to act more like a bond when we start seeing rising interest rates,” he said.

Marks said the equity income portfolio strategy has attracted $30 million in investments, with a stated target of earning a 5 percent yield before fees.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. Companies or investments mentioned are for information only, and are not to be considered a recommendation, and may not be suitable for all investors.

Stock investing involves risk including loss of principal. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.

Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). Preferred stocks may be subject to a call feature with changing interest rates or credit ratings.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. They are subject to inflation and interest rate risk.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates.It is expressed as a number of years. The bigger the duration number, the greater the interest-rate
risk or reward for bond prices.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

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