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Income-Seekers: 4 Mistakes to Avoid

Low bond yields and the prospect of rising rates have the potential to trip up yield-focused stock and bond investors.

Note: This article was updated on March 15, 2018. It's part of Morningstar's Guide to Dividend and Income special report.

After a decade of meager yields, things are starting to look up for income-focused investors. It's not hard to find cash yields of 1.5%, and the Bloomberg Barclays Aggregate Index's yield is nudging closer to 3%. Of course, that has caused some short-term pain for bond prices--nearly every bond category is in the red for the year to date in 2018--but higher yields are a welcome development for income-minded investors. It seems like another century, but as recently as 2007, CD yields were more than 3%, and high-quality intermediate-term bonds were yielding 5% or more.

But as always, the current environment also provides plenty of pitfalls as investors look to extract income from their portfolios. Here are some of the key ones to avoid.

Mistake 1: Using Bonds to Provide Liquidity The low-yield environment, combined with a remarkably placid run for both stocks and bonds for the better part of the past six years, has had the effect of nudging everyone out on the risk spectrum. Some investors who might normally hold bonds for their intermediate-term spending needs have embraced stocks, while some would-be cash investors are holding more bonds to meet near-term spending needs. When I speak about the Bucket Approach to retirement portfolio planning, I invariably receive questions about whether higher-yielding alternatives like floating-rate funds might not be a fit for the liquidity bucket (Bucket 1).

Judging strictly from past returns, that seems reasonable. While short-term bonds and floating-rate loans, unlike cash, have the potential to decline in value, investors haven't lost money in those asset classes in any calendar year since 2008, and they've been able to pick up a much higher yield than cash offers. As discussed in my recent Bucket Portfolio simulations, a retirement portfolio without a cash bucket would have beaten a portfolio with a cash bucket over the 17 years, largely because bond investors have enjoyed capital appreciation, whereas cash investors have had to settle for ever-lower yields.

But the ability for cash instruments to hold principal stable--although it's been a drag in recent years--may well be a virtue in other environments. True, high-quality short-term bond funds are unlikely to have catastrophic losses, even if yields move up more swiftly than market watchers are anticipating. But they could have losses all the same, and that could be disconcerting for money you have earmarked for next year's tuition, property tax bill, or your in-retirement living expenses.

Bank loans, meanwhile, may even gain in value during a rising yield environment; they're apt to perform reasonably well as long as the economy does. But their main vulnerability is if the economy unexpectedly weakens, as floating-rate bank loans are invariably made to companies with less-than-stellar financial pictures. In a time of market and economic duress, when you often most highly value liquidity, a bank-loan investment may experience losses.

Low cash yields argue for not holding more in cash than you need for your emergency fund or, if you're retired, to cover at least two years' worth of living expenses. But once you've arrived at an appropriate cash target, my advice is to sit tight in true cash instruments rather than venturing into higher-yielding, but also higher-risk, fixed-income alternatives.

Mistake 2: Underestimating the Risks With today's still-low yields, it's safe to say that every income-producing rock has already been turned over. If there were a foolproof way to generate extra income without additional risk, investors would already be all over it, pushing up the security's price and pushing its yield down. Instead, higher yields are invariably a signal that a security type entails more risk than its lower-yielding counterparts.

Master limited partnerships serve as an instructive recent example. With yields of 5% or 6% or more, many income-seeking investors gravitated to MLPs earlier this decade, viewing them as a way to generate a much higher level of income than is available with high-quality bonds or dividend-paying stocks. In terms of riskiness, many investors also took comfort in the idea that MLPs, which own pipelines that transport oil and gas, would hold up better than other types of energy firms in case of declining energy prices. After all, the demand for energy transport could even increase in the face of lower energy prices.

Yet MLPs have experienced dramatic price declines over the past few years, even as their yields have remained robust. Additionally, MLPs--like REITs, utilities, and other income-rich stocks--are often vulnerable when interest rates increase, because some investors will prefer the safety and newly higher yields of bonds.

Of course, buy-and-hold investors shouldn't be too unduly rattled by such price declines, especially if their income streams are uninterrupted. But if their time horizons aren't long enough, there's a possibility they'd need to sell into the weakness, turning the paper loss into a real loss. I'd recommend that investors of any equity--income-producing or otherwise--should have a minimum anticipated holding period of 10 years or longer before buying in.

Mistake 3: Not Adequately Diversifying Among Income Producers The recent travails of MLPs are also a reminder to diversify your income streams among securities that will respond to different forces rather than homing in on a single narrow subsector, even if it's one you really love.

Naturally, a portion of your income-generating portfolio will be in security types that thrive in a strong economy, even one featuring rising interest rates; think credit-sensitive bond types like lower-quality corporates and bank loans. The yields on such investment types are invariably higher than what you'll earn on higher-quality investments, both stocks and bonds, and their long-run performance may be, too. Indeed, credit-sensitive sectors bond sectors have held their ground recently, even as bond yields have trended up.

But economically sensitive investments often decline in sympathy with stocks, so they may not provide much ballast for your portfolio in a weakening economic environment. That's when boring high-quality bonds and stocks earn their keep, even though they tend to be rate-sensitive and their yields usually aren't as impressive. If your goal is to garner income while not getting unduly rattled by price declines along the way, diversifying your income streams among both high-quality, rate-sensitive investments as well as lower-quality, less-rate-sensitive securities is the way to go.

Mistaking 4: Neglecting the Drag of Taxes One outgrowth of today's very low yield environment is that high-quality bond income is so low as to seem insignificant. In turn, the tax consequences of holding income-producing securities in a taxable account have not been that meaningful in dollar terms. For example, if you have $50,000 in a short-term bond fund that's paying you 2% ($1,000) a year, and you're in the 22% tax bracket, your tax bill on that investment is $220 per year--certainly not a large sum in the scheme of things.

But you're still ceding a large percentage of your portfolio's return to taxes--a portion of your return that you would be able to keep if you held that investment inside of a tax-deferred account and reinvested your income. And now that yields have begun to rise, the dollar value of paying attention to asset location has also increased. Of course, it often happens that we want liquidity in our taxable accounts, so we need to rely on income-producing cash and bonds, but municipal bonds and municipal money market funds may be a better fit for the liquidity needs of investors in higher tax brackets.

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