Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

A Beginner's Guide to High-Income Investments

The 1970s were a very tough time for stock investors, but a great time for those that bought bonds. Many bonds offered double-digit payouts, which created great long-lasting income streams for its owners.

But interest rates have been steadily declining ever since, and it's becoming impossible to generate meaningful income from government bonds or other fixed-income investments like CDs. And that's unlikely to change any time soon. Inflation remains quiescent, and the Federal Reserve is much more concerned about economic growth than a surge in prices. It may be a year -- or more -- before the Fed thinks about boosting interest rates. And even then, rates may still be too low to help create impressive payouts from your government-oriented fixed-income investments.

But that just means you need to change your game. Instead of focusing on traditional fixed-income investments like bonds, T-bills, and CDs, look to the stock market for help.

Of course, the most obvious form of income investing comes from dividend stocks. A wide range of high-quality companies such as Kraft (NYSE: KFT) and Verizon (NYSE: VZ) offer up dividend yields in the 4% to 6% range. If that's not enough of a payout for you, check out Master Limited Partnerships (MLPs). These are specially structured businesses that must pay out 90% or more of their profits every quarter to qualify for special tax advantages. Most MLPs focus on the oil and gas distribution sector, which is noted for its steady and predictable cash flows. MLPs like Kinder Morgan (NYSE: KMP) can offer up yields in the 6% to 7% range. 

Real Estate Investment Trusts (REITs) can also offer impressive yields, though at the moment, the moribund real estate market has dampened their cash flows. These entities must also dole out almost all of their cash flow, but since their income streams tend to fluctuate from year to year, they sometimes offer especially high yields to justify the risk. In an ideal world, you would look to buy these REITs when they're out of favor. If they are yielding 4% or 5% in a bad year, that payout may end up doubling when times get better. Examples of REIT high yielders include Mack-Cali (NYSE: CLI). [My colleague Carla Pasternak is a big fan of Canadian REITs, which she wrote about in Where You Can Find 11.5% Yields.]

Total Appreciation: The Whole Package
Even as they seek income, many investors also want to see their investments rise in value. A 5% dividend payout is nice, but if the investment also rises 10% in value, you are looking at total appreciation of 15%. And that's a fine result in any kind of market. But as a general rule of thumb, the higher the projected income stream, the less appreciation you're likely to see. Those MLPs noted earlier have very little money left over after making payouts, so the business generally stays in the same financial position, year after year.

In fact, a very high dividend yield (which is the dividend paid over 12 months divided by the stock price) should give you pause. Back in the economic crisis of 2008, newspaper publisher Gannett (NYSE: GCI) saw its dividend yield rise to 18%. Investors knew that this was unrealistic and something had to give. Either the company's stock was headed for a fall, or Gannett would need to sharply slash its dividend. Sure enough, Gannett then slashed its dividend from $1.60 in 2008 to $0.16 in 2009.

How do you know if a dividend is in trouble? Check out the payout ratio, which is the amount of cash set aside for dividends, divided by cash flow. A company with $1 billion in cash flow can easily afford to pay out $400 million in dividends (40% payout ratio). But if cash flow slumps to $200 million during a recession, you can bet that the dividend will soon be cut or even eliminated. Which is the problem with dividends. Unlike bonds and CDs, you're never guaranteed that payouts will keep coming. That's why some investors stick with companies that have a history of maintaining or boosting their dividends in good times or bad. Procter & Gamble (NYSE: PG) has boosted its dividend roughly 10% a year for the entire last decade.

Investors can also get juicy payouts from preferred stocks that act like a hybrid stock and bond. Owners of these preferred stocks are first in line for dividend payments, ahead of owners of the common stock. So when a company hits tougher times, these owners of preferred stock don't have as much to fear. (At times, a company may choose to spend dividend payments on preferred stock, but will generally need to catch up with missed payments before resuming a payout for regular common stock holders.)

Major utilities and banks are best known for these preferred stock issues. The common stock of JP Morgan (NYSE: JPM) yields less than 1%. Though that payout could rise in coming years, it's unlikely to match the company's preferred stock (NYSE: JPM-PJ), which yields 6.9%.

If you strive for income, you can do much better than Uncle Sam. Focus on the income portion of public equities. Plain old dividends, MLPs, REITs and preferreds all offer a path to higher income.

[InvestingAnswers Feature: Click here to learn how to Tap Into Cash Flows with Master Limited Partnerships.]