Since 2009, Build America bonds have given yield-starved investors a bit of hope for their fixed-income portfolios. These subsidized munis may continue to be good options, if you understand the risks.
Yield-starved investors have good reason to be increasingly frustrated. Money-market funds yield next to nothing, and 5-year Treasuries yield less than 1 percent. TIPS sport negative yields. The yields are likely to remain skimpy since the Federal Reserve has announced its intention to hold down rates at least until 2014. But there are still some ways to boost income. In recent years companies have introduced a variety of funds that yield more than traditional options. While many of the newer funds have short track records, early results are compelling. By adding one or two of the latest vehicles to a fixed-income portfolio, you may be able to boost yields a bit without taking on much extra risk.
Among the most promising performers are funds that hold Build America Bonds, which yield more than 5 percent. In 2011, Eaton Vance Build America Bonds (EBABX), a mutual fund, returned 20.8 percent, outdoing the Barclays Capital Aggregate Bond Index by 12.9 percentage points, according to Morningstar. Other funds that returned more than 20 percent include PowerShares Build America Bond (BAB), an ETF, and closed-end funds such as Nuveen Build America Bond (NBB) and BlackRock Build America Bond (BBN).
Build America Bonds are municipal issues that were introduced in 2009 as part of the American Recovery and Reinvestment Act, which sought to help municipalities pay for capital projects. While most municipal bonds are tax-free, the Build America Bonds are taxable. Under the legislation, the Treasury subsidizes 35 percent of a municipality’s cost of making interest payments on the bonds.
The markets embraced the bonds last year partly because most of them carry top ratings of AA or AAA. Unnerved by debt problems in Europe and the U.S., investors fled to the safety of Treasuries and other high-quality issues.
Despite the high-quality of their portfolios, the Build America funds do come with risks. Many of the bonds have 30-year maturities. If interest rates spike, the long bonds could sink. In addition, Congressional Republicans have refused to authorize more Build America Bonds. The Obama administration has sought to continue the program. But if Congress continues to balk, the Build America funds could be forced to change their charters in a few years and buy other kinds of taxable municipals.
Real Estate and Preferreds
Another way to get 5 percent yields is with real estate income funds. Mutual funds with fat payouts include Fidelity Real Estate Income (FRIFX), Forward Select Income (KIFAX) and Lazard U.S. Realty Income (LRIOX). While most funds in the real estate category hold REIT common shares, the income funds own bonds and preferred shares as well as equity.
Like bonds, preferred shares pay fixed yields. But preferreds currently yield 7 percent to 9 percent, while bonds yield about 5 percent. The preferreds yield more because they are riskier. In the event of a default, the bondholders must be paid before preferred investors receive anything. REIT common shares yield about 2 percent.
Over long periods, stocks tend to outdo bonds and preferred shares, so the real estate income funds should trail their equity-oriented competitors. But the fixed-income stakes outperform in downturns. That has enabled the income funds to shine in the turbulent markets of recent years.
During the past five years, Fidelity Real Estate Income has proved to be a relatively steady performer, returning 3.3 percent annually and outdoing 96 percent of real estate funds. Fidelity portfolio manager Mark Snyderman keeps about a quarter of his assets in common stocks, with 20 percent in preferreds and the rest in bonds.
Lazard U.S. Realty Income varies its portfolio mix. During the turmoil of 2009, the fund had 90 percent of its assets in preferreds because many sold at big discounts. Since then preferreds have rallied. Lazard now has 37 percent of assets in perferreds and 46 percent in common stock.
Investors who are tired of earning almost nothing on their money-market funds may be tempted to try ultra-short bond funds, which yield 1.25 percent. But those can come with more risk. During the market crash of 2008, the average ultra-short fund lost 7.9 percent. To provide a safer alternative, companies have been introducing a new breed of ultra-short funds. These yield a bit more than money markets while taking less risk than their traditional peers. The new entrants include Fidelity Conservative Income Bond (FCONX), which yields 1.04 percent. Other competitors include Oppenheimer Short Duration (OSDYX) and JPMorgan Managed Income (JMGSX).
In order to yield more than money markets, the ultra-short funds hold securities with longer maturities. Under government rules, money-markets funds must have average maturities of less than 60 days. The new ultra-short funds boost yields by holding a mix that includes money-market instruments as well as securities with maturities of up to two years. Many traditional ultra-short funds hold securities with maturities of more than three years.
Some analysts worry that investors may try the new ultra-short funds without fully understanding the hazards. “When a fund yields more than 1 percent in the current environment, it can be on the risky side,” says Peter Crane, president of Crane Data.
Crane says that the latest wave of funds reminds him of a group that appeared earlier in the decade. The funds began appearing after the Federal Reserve lowered short-term rates to 1 percent in 2003. With money-market funds yielding less than 1 percent, companies began introducing ultra-short funds with higher yields. The new funds worked smoothly—until some crashed during the financial crisis. The problem was that the troubled funds boosted yields by holding toxic mortgage securities.
Portfolio managers of the latest group of ultra-short funds say that they are staying out of trouble by sticking with high-quality securities. Many of the funds have average credit qualities of A or AA. So far the cautious approach seems to be working. Funds seem to be achieving their goal of outdoing money markets while taking only a bit more risk. During the past year, JPMorgan Managed Income returned 0.42 percent, compared to a figure of 0.02 percent for the average money market. The results of the new ultra-short funds may not turn heads. But at a time of puny yields, clients may be glad for whatever modest returns they can get.