How to Beat Low Interest Rates

By Dave Kansas, Wall Street Journal

As the stock market has gyrated this summer, one constant has endured. Already low interest rates have gotten even lower.

For investors dependent on interest payments for income, especially those near or in retirement, the current environment is challenging, to say the least.

Ten-year Treasurys are paying yields (2.61%) not seen since the 1950s, except for a brief, panicky moment at the end of 2008. Some Treasury inflation-protected securities, or TIPS, are yielding nothing. And corporate bonds are getting in on the act, with IBM recently selling three-year notes yielding 1%.

These rock-bottom yields reflect pessimism about the economy, worry about deflation and persisting fear of risk. After the chaotic stock market of the past few years, capital preservation and sleeping well at night have trumped most other things. That's why even with yields low, investor appetite seems undiminished.

Low yields mean low income, which has investors concerned about risk as they try to figure out how to augment their investment earnings without taking too big a gamble. Solutions to this yield conundrum aren't easy, but advisers are trying to figure out ways to goose yield without sacrificing too much safety.

First, it's important to keep the low-yield world in perspective. Inflation is at rock-bottom levels and prices, in some cases, are falling. The consumer-price index rose a smidge in July after falling the three previous months. The annual CPI is now 1.2%, which is less than half the yield on the 10-year Treasury, which stands at 2.61%. So, while that yield is half what it was in October 2007, it's still superior to the rate of inflation.

That argument, however, doesn't resonate if someone is trying to live off the investment income of a certain amount of principal. At 2007 rates, for example, you would have needed $1 million in government bonds to generate an income of $50,000 a year. Today, you'd need nearly twice that much.

One strategy some investors are using is investing in blue-chip companies that pay good dividends. A surprising number of high-quality stocks are paying dividend yields superior to Treasurys or municipal bonds, including household names like Home Depot, which pays 3.5%, Merck, 4.3%, and McDonald's, 3.1%.

Look at a company like Johnson & Johnson, with a yield of 3.7%, says Wayne Copelin, founder and president of Copelin Financial Advisors in Sugar Land, Texas. "That's a company that's not going to go away. An investor could put together a few of these stocks and you'd soon have a portfolio throwing off 4.5% in dividend yield without too much risk."

Of course, a lot of companies that seemed eternal only a few years ago have disappeared or gone into bankruptcy. Lehman Brothers, General Motors and AIG didn't strike anyone as about to go away or in need of help as 2007 dawned, but all three soon imploded in spectacular fashion.

Mr. Copelin says he also has been doing a lot more annuity business with investors seeking to lock in stable income. Annuities are insurance products that can be purchased with a lump sum or by investing in the annuity over a period of time ahead of the payout period.

Annuities do have higher fees than mutual funds and other investments, but Mr. Copelin notes that some annuity funds will pay retirees or those near retirement annual returns of 4.5% to as much as 6%.

"In the 1990s, nobody was interested in annuities," he says. "Now they kind of like that guaranteed return."

Another tack is the "total return" approach, which mixes different flavors of fixed-income investments, such as government-agency bonds, mortgage-backed bonds or convertible bonds.

Mutual funds are the best way to diversify risk while increasing yield. In this space, Pimco Total Return Fund yields 3.2% and BlackRock Total Return Fund yields 4.4%.

"This [approach] can possibly increase the risk in fixed-income portfolios a little," says Lynn Mayabb, senior managing adviser at BKD Wealth Advisors in Kansas City, Mo.

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