Conservative investors are in a very uncomfortable position right now, as their regular sources of portfolio income have seen their payouts slashed in recent years.
Yet before you go ramping up the risk level of your portfolio just to make ends meet, you really need to consider whether doing so won’t just trade one problem for a potentially much larger one that could put your entire life savings at risk.
The income dilemma
The huge problem that many conservative investors face is that the investments they’ve traditionally relied on to provide the income they need have essentially dried up. Even prudent investors who wisely prepared bond and CD ladders to take advantage of higher interest rates in the past have steadily seen their income fall, as old CDs yielding 5% or 6% get replaced with new ones that pay only 1% or 2%.
In response, those desperate for income have piled into asset classes that involve very different types of risk. Lower-grade corporate and municipal bonds offer higher payouts than other bonds, but they also carry with them much weaker credit ratings and significantly greater chances of losses from default. Many investors have also started to give up on bonds, moving money into the stock market.
In particular, some highly specialized segments of the market have attracted a lot of attention:
1). In the natural resources space, master limited partnerships have drawn interest because of their sizable distribution yields and favorable tax characteristics. Yet ALPS Alerian MLP ETF and the MLPs that make up the fund’s holdings have returns that are highly dependent on conditions in the oil and gas industry, leaving many investors dangerously concentrated in that area.
2). Real estate investment trusts offer some of the highest yields in the market, and floods of money have poured into REITs, especially those specializing in mortgage-backed securities. Annaly Capital Management, Inc. (NLY), American Capital Agency Corp. (NASDAQ:AGNC) , and other major players in the mortgage REIT market have seen their market capitalizations soar as successive secondary offerings and high levels of leverage have greatly boosted the size of their balance sheets. Yet even having taken steps to hedge some interest rate risk through the use of derivatives, mortgage REITs are still vulnerable to any adverse conditions that threaten their ability to gain access to leverage.
There’s nothing inherently bad about any of these investments. The problem, though, is that they’re a far cry from the bonds and CDs that their new investors are used to, and without a complete understanding of what they’ve gotten themselves into, conservative investors won’t know what to expect from them or the potential problems that may arise with them.