EnvisionCap.com: Forbes Article

Quest for Yield

Marilyn Cohen, Forbes Magazine, 10.31.05

A flattening yield curve makes decent payouts harder to find. But yes, you can eke out semidecent yields still. Here's how.

The flat yield curve has been worrying bond investors for months. Right now scant difference exists between short- and long-term interest rates. You aren't earning much extra yield for the risk of extending your maturities. The Federal Reserve has been jacking up short rates while longer maturities' yields haven't budged much, likely because of heavy buying from abroad.

So even more than before, investors, whether institutional or individual, are on a quest for yield. To help you out I have scoured the field and come up with a few choice ideas that present unusual values today. Eking out a quarter- or half-point of extra yield may not sound like much, but this additional payout makes a difference over time.

In the ten years I've been writing this column, I have never once recommended certificates of deposit; I am now. That's right, boring, stodgy, dull CDs that you get at your bank. Stick to one-year certificates, yielding 4.4% or better. Longer-term CDs don't pay you that much more. If your bank won't come close to offering 4.4% for one year, see bankrate.com for the highest-yielding one-year CDs available in your state or throughout the nation. The best ones as of early October came from M&T Bank of Oakfield, N.Y., at 4.48%.

Next in my conga line of ideas is a stunningly simple one: bonds from government agencies. Investment-grade corporates yield just 0.81 percentage point over Treasurys. That's too little, given that corporate credit quality is deteriorating and the Fed hasn't finished raising rates. However, government agency spreads over Treasurys are more generous.

How come? Probably due to the Fannie Mae and Freddie Mac accounting scandals and continued congressional balance-sheet scrutiny of them. But hey, take advantage of this. The federal government will not allow these entities to default. Despite all that has gone wrong, they still get the highest credit ratings.

In mid-September Fannie, Freddie, the Federal Farm Credit Bank and the Federal Home Loan Bank all issued five-year, 5% coupon bonds at par. Call protection varied from 2 to 24 months. These issuers come to market almost every day, hence there's plenty of paper to go around. With the agencies, purchase only new issues so you are guaranteed a fair price. Get all the details on the call features to see which issue is the best buy.

Five-year corporates with the same credit quality, like Wal-Mart noncallable bonds, pay just 4.7%. To get better yields from corporates, you must go down the credit ladder. In the same week as the agencies came to market, Marsh & McLennan issued five-year, 5.15% bonds rated a near-junk BBB by Standard & Poor's, Baa2 by Moody's. Or there's the BBB-rated Health Care Property 4.875% five-year noncallable corporate at 99.6 cents on the dollar for a 4.97% yield to maturity.

If you insist on a corporate issue, look at preferreds--they're more liquid than bonds and are sold at smaller prices ($25 or $100, versus $1,000). Search for preferreds with yields that readjust with prevailing interest rates. Southern California Edison (100, EIX) at 5.35% is BBB- rated by S&P, Baa3 by Moody's. This 4-million-share issue came to market at $100 in April 2005. At par they earn 5.35% until April 2010. Then, if rates are lower, these will be called or, if they are not, the dividend will rise, reset quarterly. The reset formula: 1.45 percentage points higher than whichever is paying the most: three-month London Interbank Offered Rate (Libor), 10-year Treasurys or 30-year Treasurys. So whether the curve is flat, positive or inverted, you get the benefit. Although these securities are called "preferreds," they look more like bonds than stocks, and their coupons are eligible for the 15% tax rate on dividends.

If you like the moving-parts concept yet can't live with Southern California Edison's lowish yield, try a junkier preferred. Scottish Re Group (25, SCT), a global life reinsurance company, is rated BB- by S&P, Ba1 by Moody's. Scottish Re sells life insurance and what they call "wealth-management products."

In June the company issued 5 million preferred shares at $25. Since credit quality is far from pristine, you get paid for the risk: a 7.25% dividend until July 2010, and then (assuming it doesn't get called away) 3.5 points higher than the highest of--once again--three-month Libor and 10- or 30-year Treasurys.

It's challenging, even for professionals, to know where to invest in the fixed-income market when the yield curve is flat and low. That's why you should be prudent and spread your money around. Other than the CDs, though, don't concentrate in one-year instruments. You will blink, the year will be over and then you must go through the hassle of reinvesting a lot of money.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.