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By | 11-19-2015 12:00 PM

Opportunities and Pitfalls in Income Investing Today

From dividend payers to intermediate-bond funds and more, we survey the risks and rewards for investors seeking income in the market.

Note: This video is part of Morningstar's November 2015 Income Investing Week special report.

Jeremy Glaser: Investors have been struggling with how to navigate the low-yield environment for quite a while now. And even if the Fed does raise short-term rates slightly in December, we're going to be in a low-yield environment for years to come.

So, what are investors who need a stream of retirement income to do? Do they take on more risk? Do you rely more on capital gains?

I spoke to several Morningstar experts to get their takes on the opportunities and pitfalls in income investing today.

Christine Benz: The risk of looking to a portfolio to provide a stable stream of income is that prevailing yields buffet around quite a bit, and so you may be forced to venture into riskier and riskier securities to get the payout that you're looking for. I think a better idea for most investors, especially retirees, is to plan to be opportunistic about where they go for income. In some good years, they may be able to get all the income they need from their dividend-paying stocks and from their bond yields. In other environments--like the current one--I would argue it pays to be opportunistic and think about how maybe I'm getting some of my income from my portfolio, but I may also have to do a little bit of rebalancing--trim some of my highly appreciated equity positions and use that to make up the shortfall if my income, alone, isn't insufficient.

Glaser: One area in which many investors have turned to generate an income stream is dividend-paying stocks. I talked to Morningstar's Josh Peters about some of the risks in dividend investing and also what some of his favorite stocks are today.

Josh Peters: In that 3% to 4% or 4.5% range--right now my portfolio is right around 4%--I think that's the sweet spot. You're still going to get safe dividends as well as dividend-growth potential that's going to exceed inflation, and you're not exposing yourself to as much risk that earnings growth comes up short or the risk that the market figures out that the earnings growth is not there and we stop seeing this capital appreciation in the absence of earnings growth that we've had over the last couple of years. To me, the best way to ensure that you at least get a mid-single-digit return is to start with a mid-single-digit dividend yield.

If you're going to pursue income, interest-rate risk is something I think you're just going to have to be willing to accept, but it's a trade-off. The inverse of interest-rate risk--you may think of it this way--is economic risk. And if you own these defensive companies with higher dividend yields but more-secure cash flows, they may not have as much upside potential in a faster-growing economy that would correlate with higher interest rates; but if the economy goes south, these are the companies that are going to preserve their dividends and probably continue to raise them even as more-cyclical companies are seeing significant share-price decline. The key point is to make sure you're not overpaying for stocks. Make sure you're paying attention to valuations and getting dividend yields that are consistent with the kind of growth that you can expect in a normalized interest-rate environment.

One of my favorite high-yield names right now is Ventas (VTR). They are one of the largest REITs that specializes in healthcare real estate, and the largest piece of their portfolio is senior housing. There has been some concern this year that has had an effect on all of the players in the industry that perhaps senior-housing developers have overbuilt and there is a little bit of excess supply. It has driven Ventas down quite a bit and driven that yield up in tandem. But this is one of those situations where if there is some cause for a concern, first you look to the margin of safety. The dividend is very well covered. The balance sheet is not overstretched or overleveraged. The bulk of the company's cash flow is still locked up under triple-net leases. They do have some owner-operator exposure, but not so much that the dividend is at risk. So, in the case of Ventas, I think you can count on that dividend yield that you're getting upfront. I still think you're looking at mid-single-digit dividend growth or better over the next five to 10 years. So, that's really a very strong total-return prospect for a stock with these yield and risk characteristics.

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