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Income Seekers: Handle These Investments with Care

Income Seekers: Handle These Investments with Care

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Susan Dziubinski: Hi, I'm Susan Dziubinski with We're in an era of ultra low yields, and that is leading many retirees scrambling for income. Here with me today to discuss some income ideas that retirees should be very careful with is Christine Benz. Christine is Morningstar's director of personal finance. Christine, thanks for being here today.

Christine Benz: Susan, it's always great to be here. Thank you.

Dziubinski: Now, before we get into the specifics, let's talk a little bit about the backdrop today, which is this ultra low-yield environment. Let's talk a little bit about that and why we're here and how we got here.

Benz: Well, it largely owes to the pandemic and the economic aftereffects of the pandemic. So the Federal Reserve has taken interest rates way, way down. Part of it is Fed policy; part of it is investor demand. What we saw during the market shock, especially in the first quarter, was that some investors realized they had been underappreciating the role of safe securities in their portfolio. We've seen demand for high-quality bonds, cash instruments spike, and that has the net effect of pushing yields down. People who want a higher yield have no choice but to gravitate to higher-risk investments.

Dziubinski: What do you suggest that retirees do in this type of environment--the retiree who's looking to generate that cash flow?

Benz: I'm a big believer in thinking about cash flow versus yield or income. And the key reason, Susan, is that I think you want to think about your cash flows in retirement as another way that you diversify. So just as you diversify your portfolio by holding different asset classes, I think you want to think about building a diversified cash flow in retirement, as well. Maybe you do include income producers as a component of the cash flow you rely on to meet your living expenses, but I think that given very low yields today, we have to be realistic and understand that the only way that most retirees will be able to derive a livable cash flow from their portfolios is to periodically harvest some appreciated securities and use those for living expenses, as well.

We've had a tremendous long-running rally in the equity market. We have had periodic shocks, such as what we had in the first quarter, but my view is that for many retirees today, their best source of cash flow, maybe for the next couple of years, would be to harvest appreciated equity holdings, assuming that they sat tight with their equity positions through the turbulence, which is not to say they should sell all of their equity holdings but certainly use them as a component of their cash flows.

Dziubinski: Now let's pivot a little bit and talk about some of those income-producing investments that retirees, or income-seekers in general, may be looking to at this low interest-rate climate time. What are some things that you think investors should really avoid with a 10-foot pole?

Benz: Right, so I wouldn't say it's a broad basket, but there are a few different investment types that fall under this umbrella of "don't touch with a 10-foot pole." One would be structured notes, and our colleagues, Amy Arnott and Maciej Kowara, wrote a great research piece about these products, kind of diving into the pros and cons, and mainly the cons. Structured notes, business development corporations, as well as nontraded REITs or private REITs. I would say that the commonality is that all of these investments tend to have high incomes attached to them, so they can be tantalizing from that standpoint, but they're also opaque, so they can be difficult to understand what you're getting, which is always a red flag if you're looking at an investment type. So that they can be complicated and opaque. They can also be illiquid in periods of market duress. And that's what we've seen with a lot of these categories through this recent market shock where investors have wanted to get out. In some cases, maybe the volatility was more than they expected, or in some cases, they've had yield reductions. Well, guess what? They can't readily get out. So all of these investment types do have attractive yields, but I would say avoid them and really understand anytime you see a double-digit yield on something in an era where high-quality bond yields are in the very low single digits, understand that you probably will not get that very high yield. And you'll certainly get a lot of volatility along with it, as well.

Dziubinski: Now there's a second group of investment options for income-seekers that you say are more "handle with care," not necessarily "avoid entirely"--just make sure these are good fits for your time horizon and your risk tolerance. What are some examples of some of those?

Benz: This would be the whole category of lower-quality bonds. So this would encompass high-yield or junk bonds or junk-bond funds, bank loan or floating-rate investments, multisector-bond funds, which are a little less junky than the first two groups, emerging-markets bonds, any of those categories where you do have higher yields but also lower quality and higher risk. I would say just make sure that, even as you may want to add them to your portfolio to goose your overall yield, I think you want to be careful to rightsize your allocation to them.

I would typically think of fairly low overall positions in all of these categories. You also want to make sure that you have a really long time horizon for them. So in my bucket portfolios, to the extent that I have these categories, I've typically held them alongside equities and thought of them as kind of equity alternatives. Because when we look at the risk/reward characteristics of these products, that's kind of where they're aligned, more so with equities than with high-quality bonds. So you want to make sure you have a long time horizon just as you would with the equity holdings in your portfolio.

Dziubinski: Now, Christine, what about master limited partnerships, specifically? Are they in the "don't touch with a 10-foot pole" bucket or are they in the "possibly tread with care" bucket?

Benz: I would say that this might be a category that investors could consider in small doses. By no means is this a must-have category for most investors. These are companies that operate pipelines--own and operate energy pipelines. And what we've seen in this market shock, as well as in the financial crisis, was a significant amount of volatility. Some dividend cuts--that these companies are economically sensitive, they tend to run into trouble in periods of economic weakness, like what we're living through right now. Incomes can be really attractive, which is why people like them. There are also some tax-efficiency characteristics if you hold them in a taxable account. But generally speaking, I think investors want to be mindful of what a narrow category this is. To the extent that they own them, and perhaps they're doing a little bit of contrarian investing, given how beaten up MLPs are today, just really do rightsize the position and own them with a nice long time horizon in mind.

Dziubinski: Christine, thank you so much for your income insights today. We appreciate it.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski with Thank you for tuning in.

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