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By Jason Stipp | 12-19-2011 05:03 PM

Dorsey's Picks for Alternative Income

A diversified portfolio including MLP, trust preferred, and mortgage-backed securities can return a decent yield in a market where traditional income sources are lacking, says Sanibel Captiva Investment Advisers' Pat Dorsey.

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. With bond yields continuing to be at such low levels, income investors have to ask themselves some tough questions lately. Here with me to help investors work through the tough yield environment is Pat Dorsey, he's President of Sanibel Captiva Investment Advisers.

Thanks for joining me, Pat.

Pat Dorsey: Anytime, Jason.

Stipp: So, it has been a tough environment for income investors. We see that yields are persistently low on fixed income, yet we know that a lot of investors are moving into retirement, and income is on their minds.

What are some of the key broader questions that investors should be asking themselves when they're trying to build an income portfolio, given this tough environment today?

Dorsey: I would say one thing is ... think hard about how you view safety and risk, because the risk that your income stream from, say, a Treasury at 2% or a J&J bond at 2.5%, doesn't keep up with the cost of goods, doesn't keep up with inflation over 10 years, that is just as real a risk as the higher volatility risk you might take owning say Abbott Labs equity or Johnson & Johnson equity, for example.

Day-to-day volatility is how risk is commonly defined in the academic literature, but the reality is that if the dollars you get from those bonds are worth less in 10 years than they are today, that's a risk to you as well.

Stipp: So, I think, that's more of a longer-term risk, maybe harder for folks to conceptualize versus the risk I might lose some money tomorrow or next week. But I think that one of the issues that they have right now is these areas that they normally would go into just aren’t really doing it for them as far as fixed income, and so we have fixed-income yields that aren't very good, but then we also have investors that are looking out in traditional areas that they consider safe like utilities, but you tell me that maybe this isn't exactly the best place to be in, either?

Dorsey: No, not at all. I mean, utilities have had a wonderful run over the past two, three years, as this search for yield has really driven up their valuations. And of course, we have to remember that for every security, you get return from three places: the dividend, the earnings growth, and in the change in valuation. And a big chunk of the return on utilities over the past few years has come from rising valuations.

You have companies like say Southern and Duke Energy, which are wonderful utilities, very well-run businesses, still with good yields, but trading at sometimes 14 and 16 times earnings, which is a premium to the market, and these are businesses that will never grow at more than maybe a mid-single digit rate. So it's not nosebleed, this isn't Cisco at a 100 times earnings, but it certainly introduces an element of risk, that I don't think most utility investors are comfortable taking.

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