Investing with the goal of creating steady income for retirement can be a real challenge, especially when interest rates remain near all-time lows. The good news for investors is that there is an expanding universe of income-producing products to choose from. The five most popular income investments and how they compare to mortgage pool funds are discussed below:
1. US Government Bonds
Investors can lock in reliable income by owning US government bonds or CDs, although the returns on these assets are close to multi-year lows. At present, 12-month CD yields are below 1%, five-year Treasury yields are approximately 2% and ten-year Treasuries yield 2.5%. Despite a reputation as very safe investments, government bonds have a poor track record of keeping ahead of inflation. With inflation averaging 3% a year over the past century, an investor who held a bond that yields 2% would have lost significant purchasing power.
Despite the Federal Reserve signaling multiple interest rate hikes this year, actions likely to re-kindle inflation, as noted in this Kiplinger article, at today’s prices Treasuries still aren’t pricing in inflation. The last time ten-year Treasury yields were this low was during the Great Depression. Holding a longer-term Treasury in an inflationary environment creates the risk of being locked into below-market rates or forced to sell at a loss to move capital into better-yielding assets.
Many income-hungry investors have turned to Real Estate Investment Trusts (REITs) to boost portfolio yield. REITs are pass-through investments that operate under special tax rules requiring the majority of their earnings to be paid out to investors as dividends. Unlike US government bonds, over the long-term REIT shares have usually kept pace with inflation.
At present, equity REIT yields are attractive at 3.9%, or nearly double the S&P 2.0% dividend yield. However, REIT dividends haven’t always been reliable. As noted in this Forbes article, 78 REITs cut or suspended dividends during the 2008 financial crisis.
REITs also face several near-term challenges. Even a modest slowdown in the housing market may hurt their ability to increase rents, their principal source of income growth. In addition, many retail REITs are struggling as competition from on-line retailers has slowed shopping center traffic to a trickle. Some financial advisors argue that REITs are already overvalued; in the last five years, the S&P U.S. REIT index has risen by nearly 60%.
Yields on Business Development Corporations (BDCs) are attractive, with many BDCs yielding upward of 10%, but several factors make this sector somewhat risky. Depending on the BDC, a large portion of the portfolio may consist of mezzanine debt that is illiquid, unsecured and subordinated. In addition, about 10% of BDCs invest in risky private equity securities. BDC managers typically leverage their portfolios, often lending $1.5 for every $1 of capital held. Dilution risk is often high since equity raises are needed to bring in new capital. During the Recession, several BDCs nearly folded and virtually all BDCs cut or suspended dividends. Approximately one-quarter of BDCs cut their dividends in 2016.
Master Limited Partnerships (MLPs) are popular with income investors due to generous yields often exceeding 5%. However, most MLPs are primarily involved with the energy sector. MLPs own pipelines, oil and gas storage facilities and exploration and production businesses. Declines in energy prices often reduce dividends and share prices in this sector. Most MLPs must borrow money or issue new shares to grow their operations and cash flow. Many MLPs also have substantial debt loads, which will often cause cost of capital to rise as interest rates climb.
5. Other Types of High-Dividend Stocks
Shares in public utilities are often referred to as “widow and orphan” stocks due to their lack of volatility and rich dividends. Yields on utility stocks currently range from 3% to 5%. A major disadvantage of utility stocks, however, is their limited growth potential. Most utilities are regulated, which means that rate increases must be approved by government regulators. Rate increases are generally modest. As a result, dividend growth for utility stocks averages only around 2-3% per year and price gains over time tend to be minimal.
When compared to bonds and dividend-paying stocks, mortgage pool funds have several characteristics that make them attractive income investments.
The first is safety of principal. Mortgage pool funds manage risk by requiring a significant down payment from borrowers, requiring the borrower to retain an equity stake, securing loans with physical real estate and restricting loan amounts to less than 70% of property value. A big spread between the loan amount and the value of the property means that no losses are suffered if the borrower defaults and the property must be sold to recoup the investment.
Another advantage associated with mortgage pool funds is the diversification they bring to a portfolio. This is due to real estate’s low correlation with stocks and bonds. Real estate is also an effective hedge against inflation since rent increases and home prices generally keep pace with inflation. When first introduced more than 50 years ago, REITs also provided diversification benefits. However, as the REIT sector became larger, REITs have begun behaving more like other stocks and much of the diversification benefit has disappeared.
An important factor differentiating mortgage pool funds from other fixed income investments is their ability to more rapidly redeploy their capital. This is because mortgage pool fund loans are generally short-term in nature; the typical mortgage pool loan matures in one to three years. During periods when interest rates are rising, rapidly maturing loans enable mortgage pool funds to reinvest quickly to capture higher rates. Short maturities on loans in their portfolios and focusing exclusively on a specialized lending niche are reasons that mortgage pool funds can offer reliable dividends and higher yields (currently between 8-10%) than most other fixed-income investments.