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By Andrew Gogerty | 08-26-2009 03:07 AM

Income Investors Must Expand Horizons to Beat Inflation

WHG Income's Mark Freeman says investors will have to look at nontraditional areas of the income market to offset the impact of higher inflation.

Securities mentioned in this video



WHGIX	Westwood Income Opportunity Instl

Andrew Gogerty: You know one of the headwinds to income or one of the things that can really put a damper on it is inflation. And it has been talked about for a year, year-and-a-half now, but I'm curious to get your opinion or insight as a bond investor or even in bond investing in general. How can investors or what steps should they look at to potentially fight that if they have the opportunity to?

Mark Freeman: If inflation becomes an issue, income investors are going to have basically be more flexible in terms of their opportunities that they are willing to consider. If you look at traditional fixed income and where yields are today, there is not much room or protection for higher inflation down the road for those securities.

So I think income investors are going to have to again broaden their perspective in terms of the types of asset classes that they are willing to consider and look for opportunities in those other income-oriented asset classes, because especially in an higher inflation environment, as we all know, in a fixed income environment where basically the coupon payment is fixed, inflation is basically the worst thing for a bond investor. And so the potential for capital appreciation to potentially offset some of the negative impacts from inflation becomes really of critical importance.

So having said that, I think that's one aspect that investors can focus on. From there, the others are going to be explicitly inflation oriented type securities likes TIPS (Treasury Inflation Protective Securities). So I think those types securities also are going to have to play a role.

But at the end of the day, investors are going to have to be flexible and they are going to have to be willing to look at perhaps some nontraditional areas of the income market in order to meet and to offset, if you will, the impact of higher inflation should that come to pass.

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Gogerty: It seems like looking, like you said, across asset classes and maybe not just at the blue chip dividend paying stocks and the investment grade corporate bonds that everyone knows is going to be kind of crucial to keeping pace with that inflation if it does in fact turn around.

Freeman: I agree with you absolutely on that front, I think that is going to be critical. The other thing I would point that I think investors have to keep in mind and you mentioned blue chip stocks or equities that typically have high paying dividend and things of that nature.

I would say that while the level of the dividend is important, i.e. the yield, but what I think is even more important, especially if we have higher inflation, is that company's ability to grow that dividend in excess of the rate of inflation.

Gogerty: OK.

Freeman: Because ultimately what you need to see as an investor is you need to preserve the real yield if you will and ideally you would like to see that grow in excess certainly to the extent possible, because ultimately that's what benefits investors.

So I would say that if you are looking at individual companies and owning the equity of those companies there, then you want to focus on the payout ratio and the level of free cash flow and what type of capacity does that company have to grow that dividend going forward.

So I think again, it speaks to the overall environment and whether or not we have higher inflation or not, the role of dividends to investors, i.e., the income component, from our standpoint, we think that that's just only going to grow in importance. We have seen on an historical basis where the dividend or the income component constitutes a very significant portion of the total return and some can argue that over the last couple of years, it has been all of it, actually more than 100% of the return for that.

So I think again going forward investors are clearly looking for income and I think that that will certainly be important in the future.

Gogerty: Great. Well, thank you for taking the time today and for stopping by. I appreciate it.

This has been Andrew Gogerty with Morningstar and Mark Freeman of the WHG Income Opportunity Fund. Thank you for joining us.

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