The Money Class (36 page)

That is one reason why I always recommend that once you leave a job (or turn 59½) that you move money out of a 401(k) and into a rollover IRA. Most 401(k)s only offer bond funds, whereas with an IRA at a discount brokerage you have the flexibility to invest directly in individual bonds.

And the big lesson here is that bond funds that own long-term issues will be the most vulnerable if interest rates rise. Remember, when rates rise the price of bonds declines. The longer the maturity, the bigger the decline. If you want to have your money in short-term bond funds (maturities of 3 years or less), that’s okay; given the very short maturity, your potential loss will be much less in a rising rate environment. But I have to point out that in early 2011 the yield on a supersafe 1-year bank or credit union CD looks a lot smarter to me. Any money you don’t expect to need for a year or more just might be better off in a bank account.

BEYOND TREASURY BONDS: OTHER BOND INVESTMENTS

Investing in Treasury bonds offers important safety: The bond is backed by the full faith and credit of the United States Treasury. No matter what you may think of our current state of affairs, that promise is rock-solid. But there is an obvious trade-off: Typically the interest you can earn on Treasuries is lower than other types of bonds. Here is what you need to know if you want to venture beyond Treasury issues:

Municipal Bonds

I have made no secret of the fact that since 2007 I have been in love with municipal bonds. But investing in municipal bonds is indeed tricky today. Not only have bond values already risen sharply, but we now must consider the troubling finances of states and municipalities that could impact their ability to pay their bond interest. I want to stress that to date, muni bond defaults have been extremely rare. But the fiscal straits of many states and cities are very real. That just increases the need to be extra careful and smart in how you invest in municipal bonds.

Municipal bonds are issued by state and local governments and public agencies to help finance public projects. There is no federal income tax on the interest you earn on a municipal bond. If you live in a state that levies a state income tax, interest from a bond issued by an entity within your state can also be free of state tax. If your retirement income is still high enough that you are in the 35% federal tax bracket, the tax-free yield can be a good advantage. There is of course the risk that if the state or municipality that has issued a bond falls into dire financial shape it could have trouble making all its interest payments. To date this has been extremely rare. Still, I would only recommend you invest in municipal bonds if you have a trusted advisor who specializes in building a well-diversified portfolio of high-quality municipal issues.

Trusting most of the rating agencies and buying bonds with safe ratings is not good enough today. Nor is buying general obligation bonds in certain states. I myself have switched from buying general obligation bonds to general revenue bonds that are tied to an essential public service, such as water service. I think general revenue bonds for essential services can be a smarter investment in this environment. People tend to keep paying their bills for essential services, so bonds whose own payments are made from that revenue flow are likely to have a steady source of money to keep paying their bond interest. As I write this, the states that currently are in the biggest financial trouble are California, Illinois, New York, New Jersey, and Florida. That is not to say all the other states are healthy, mind you; you have to do your homework here. You have to know what backs the bonds, the condition of the state, and the risk you can afford to take. So if you are going to invest in municipal bonds at this point in time, you really have to know what you are doing. Again, I would encourage you to seek out the help of an expert in municipal bonds and make sure you are thoroughly diversified among various states—and be aware that you might end up owing state taxes on some of those.

Corporate Bonds

Please be very careful if you are buying corporate bonds. I recommend sticking with high-quality bonds rated above BBB. And the same maturity rule applies; I don’t think you want to own corporate bonds that mature in more than 5 years. Now, I know many of you may be investing in high-yield corporate bonds, which are also called junk bonds. They definitely pay much higher yields; in early 2011 the average yield for an index of junk bonds was near 8%. I want you to understand, however, that junk bonds are nothing at all like regular bonds. They pay that higher yield because there is a higher risk that the company that issued the debt could run into financial trouble and not be able to honor its payments. Even if that doesn’t come to pass, when the markets are volatile, junk bonds will resemble stocks more than bonds. Consider that in October 2008, as the financial crisis was deepening, an index of junk bonds fell 20%! My recommendation is that if you want to invest in junk bonds, you think of them as part of your stock portfolio, not your bond portfolio, because of the risk factor.

Okay, I bet you’re getting a little frustrated with me as I tell you not to chase higher yields in the bond market. Stick with me. I actually have a plan that will allow you to earn yields of 3% to 5% or higher without investing in long-term bonds.

LESSON 5.
EARN HIGHER YIELDS BY INVESTING IN DIVIDEND-PAYING ETFS AND STOCKS

Yes, as I write this in early 2011, I am recommending ETFs and stocks over bonds for generating income to help you meet your living expenses.

Stocks belong in most every retiree’s portfolio. From a pure planning perspective, if your retirement spans 20 or 30 years, having a small portion of your assets invested in the stock market, with its history of providing inflation-beating gains, makes a lot of sense. And for those of you who intend to leave assets to your heirs, your time horizon is even longer. You need to consider the life span of your beneficiaries—your children and grandchildren.

There is also a timely reason to consider investing in stocks. As I explained in the prior lesson, it is likely that we will see interest rates rise in the coming years and that will present challenges for bond investors. As tempting as it is to think that bonds are the best place to be right now, that is only using the rearview mirror as your guide. And you must look at the road ahead. In an economy where interest rates are rising, bond returns will not be as great as they have been over the past 20 years.

Let’s be clear: I am not telling you to sell all your bonds and invest everything in the market. What I am recommending is that you take time to consider seriously what the proper mix of stocks and bonds would be for you to meet your goals. As a retiree, most of your money absolutely belongs in bonds and cash. Most, but not all. Let’s go back to that very good rule of thumb: Subtract your age from 100. That is how much you might consider investing in stocks. So if you are 75 I am recommending you consider keeping 25% of your investments in stocks. That is just a guideline; if you have lots of other retirement income—pensions, etc.—and you don’t think you need stocks, that’s fine. Or if you want to focus on a longer-term strategy for your heirs and keep 30% in stocks, that’s also fine. You must stand in the truth of what is best for your life, right now and in the years ahead.

THE CASE FOR DIVIDEND-PAYING ETFS AND STOCKS

Not all companies pay a dividend, but many do. Dividends are a retiree’s best friend. Actually, they are great for investors of all ages, but they are especially smart for retirees in search of income. To start this lesson I want to review a point I made earlier: As I write this in early 2011, a six-month certificate of deposit (CD) has a yield of less than 1%. In 2008, before the financial crisis, that same CD was yielding 5%. Let’s say you had $250,000 that you kept safe and sound in CDs. Three years ago that portfolio might have generated $12,500 in interest. In late 2010 the same account would be earning just $2,000.

I mentioned all of that at the start of this class, but I think that is shocking enough that it deserved to be written twice.

And I know it is creating a dangerous problem for many of you. Because your bank deposits and CDs aren’t producing enough income, you are withdrawing more of your principal to make up the difference. Using the same example, if you needed to make up the $10,000 shortfall, you would withdraw the money from your $250,000 balance, leaving you $240,000. That leaves you less money to be earning interest. And you and I both know that if you have to withdraw even more—and keep it up for years—you are putting yourself in danger of running out of money. I cannot imagine a more harrowing way to spend your golden years than watching your funds dwindle.

So what I am about to suggest is a strategy that our grandparents and their fellow retirees used to pay their bills years ago. If you focus your investments on dividend stocks with a long history of paying out, you will have yourself a steady income stream. As I write this in early 2011 there are many high-quality stocks that have dividend yields of 3% to as much as 6%. Compare that to the 1% you can currently earn on a short-term CD and you can see why I think dividend stocks can be a great solution to your income shortfall.

Now, that said, it is absolutely true that any stock investment is going to be more volatile than investing in a CD or a short-term bond fund. I do not recommend that you invest any money you think you will need within 10 years or so in stocks. But remember how we talked earlier about the need to own stocks as well as bonds and cash? The fact is, the stock portion of your portfolio can do double duty for you right now. It can provide the opportunity for long-term growth that we know is important given the odds you will live a long time. But while you are investing for that long-term growth you will also receive an income payout—the dividend—that is in fact higher than what you can get in bonds these days. And unlike bond interest rates that are fixed, a dividend can increase over time. That’s an important way to keep your money growing along with inflation.

I want to repeat this important point:
As long as you know you will not need to sell a stock in the next 10 years or so to cover your living expenses, dividend-paying stocks are a great way to generate income.

I think the smartest way for most of you to invest in dividend stocks is by investing an exchange-traded fund (ETF) that specializes in dividend-paying stocks. An ETF will typically own at least a few dozen individual stocks, so with one investment you will own a diversified portfolio of stocks. For those of you with at least $100,000 or so to invest in stocks, direct investment in individual issues can indeed make plenty of sense. That is how I invest in dividend stocks. Later on in this class I share some guidelines for how to build a portfolio of individual dividend-paying stocks. But I want to stress that I think using ETFs that focus on dividend-paying stocks is a great way to own a diversified portfolio of dividend stocks.

Why do I want you to be protected by diversification and not just buy individual dividend-paying stocks? Let me answer that one by giving you an extreme example. For years BP, British Petroleum, paid shareholders 6% dividends, month in, month out. Then in April 2010, disaster struck in the Gulf of Mexico when a BP oil rig exploded, killing eleven people and touching off an environmental disaster. The stock price crashed, falling more than 50% by July, when the spill was brought under control, and the firm stopped paying its dividend for 2010. And as some of you may have experienced, in the wake of the 2008 financial crisis many banks abolished or sharply reduced their dividend and have yet to restore those payments. Diversification affords protection from the volatility of any given individual stock.

I also want to stress another point about ETFs that invest in dividend-paying stocks: While I think they deserve to be a permanent part of your retirement portfolio given their ability to help you manage inflation, at the same time I recognize that there is indeed much greater peace of mind for many of you by sticking with bonds. As I have explained, the current interest rate environment makes it likely that we will see bond rates rise in the coming years. Until that happens, I hope you will consider adding dividend-paying ETFs or stocks to your portfolio to produce more income. But then, once you see rates rise to a level that you are comfortably certain will provide you plenty of income, you can consider redirecting more of your money into bonds, if that is the truth that will make you feel more secure.

STOCK DIVIDEND BASICS

Some publicly traded companies choose to give a portion of their profits back to their shareholders over the course of a year. That payment is called a dividend. For every share of stock you own, you are entitled to the per-share dividend. For example, let’s say you own 10 shares of the XYZ Corp. And the XYZ Corp. pays a quarterly dividend of 25 cents. That means that four times a year you get 25 cents for each share you own. So over a year you would collect $1 for each share you own; in this case, your 10 shares would entitle you to a dividend payout of $10 a year. You are paid that dividend simply because you are a shareholder.

Dividend yield
is the per-share dividend divided by the share price of the stock. So let’s say you buy a share of the XYZ Corp. for $35 and the company pays a per-share annual dividend of $1. The $1 dividend divided by the $35 share price means your dividend yield is 2.86%. In fact, some solid companies have dividend yields of 3% to 5% or higher. Utility and telecommunication firms such as ConEd and Verizon were yielding 5% or more in early 2011. By way of comparison, a 10-year Treasury bond in early 2011 had a yield of about 3.5%. And remember, a 10-year bond maturity is way too long, in my opinion, given that when general rates rise, longer-term bonds will suffer the biggest price declines, and so if you hold on to that 10-year bond for the entire 10 years you have no chance of earning a higher yield. In other words, there is indeed “risk” in owning a 10-year Treasury. So what if you were to keep your money in a 1- or 2-year Treasury bill instead? Well, your yield in early 2011 was less than 1%.