[Editor’s note: This book was published back in 2005.]
In light of market conditions today, and what we have been through in the years since the book was published, the book will be of even greater interest to income investors today than when it was published.
At the very start of this book, the authors make a crucially important point that very few market pundits were paying attention to at the time. Given the very low dividend yield of the stock market back in 2005-2006, the future price appreciation potential of stocks looked very dubious. At that point in time, however, too many people were totally absorbed by the amazing performance of emerging markets stocks and real estate, both of which were generating 20%+ annual returns. Even domestic stocks had three-year annual average returns of more than 13% per year. The best part though was that we got this return with very low volatility. Given the fundamentals, Stein and De Muth argued that an income-focused strategy made a lot of sense.
Today, we find ourselves in the same situation in many ways. The yield of the S&P500 is around 2%, and there is little reason to believe that stocks are under-valued. In addition, yields on government bonds are historically low. Investors who wish to maintain income portfolios must look to a broader range of income-generating assets. This book is written to provide an overview of the universe of asset classes that are appropriate for income investors and the key features of each. I provide a list of topics provided in the book, some thoughts on why this book is so useful, and then add my own perspective.
The book starts with introductory chapters on the major income-generating assets, how they work and what to look out for. The key topics are outlined below:
Chapter 3: Bond Basics
Covers factors that determine the bond yield:
- The yield curve
- Basics of bond ratings
- Yield vs. ratings
- Government bonds
- Corporate bonds
Chapter 4: Risks and Rewards of Bond Investing
Covers the primary sources of risk associated with bonds, including:
- Historical risk vs. return for different types of bonds
Chapter 5: Essential Bonds for Fixed-Income Investors
- Ultra-short bonds
- Short-term bonds
- Agency bonds
- Investment-grade corporate bonds
- High-grade municipal bonds
Chapter 6: Higher-Yielding Bonds
- Foreign bonds
- Leveraged bond funds
- Emerging market bonds
Chapter 7: Stocks for Income
- Historical yields on stocks
- Changes in corporate practice with respect to dividends
- Different types of income funds
- Differences among dividend index funds
Chapter 8: Preferred Stock
- Key properties of preferred shares
- Use of leverage in preferred stock mutual funds
- Tax implications of investing in these funds
Chapter 9: Real Estate Investment Trusts
- What is a REIT?
- Major classes of REITs
- Leverage in REITs and REIT funds
- Historical risk and return characteristics of REITs
- Special interest rate risks associated with REITs
Chapter 10: The Special Case for Annuities
- What are annuities?
- Different types of annuities
- Interest rate and inflation risk in annuities
- Look out for high fees
- The annuity is only as good as the compost selling it
Chapter 11: Approach These Income Strategies with Caution
- Mortgage REITs
- Junk bonds (a.k.a high-yield bonds)
- Loan-participation funds
- Convertible bonds
- Reverse mortgages
- Long-term Treasury bonds
- Long-term corporate bonds
- Royalty trusts
- Master limited partnerships (MLPs)
Chapter 12: Your Income Portfolio
- Building a diversified income portfolio
- Getting the most yield for your risk level
- Managing inflation risk
- Managing tax exposure
The content of this book is remarkably broad. After reading this book, almost any reader will have learned something new. Did you know that an issuer of municipal bonds (say, a city) that is told that its bonds will have a poor rating can get a high rating by buying insurance against default (municipal bond insurance)? Did you know that the principal value of some bonds issued by emerging market countries is backed by U.S. Treasury bonds? Did you know that some bond funds use leverage to boost returns (and I am not referring to leveraged ETFs)? Do you understand the difference between an equity REIT and a mortgage REIT? Did you know that many REIT mutual funds use leverage to boost yields?
A number of the topics in the paragraph above have to do with issues of leverage—e.g. buying securities with borrowed funds to increase yield. For investors who have not previously encountered this topic, it is worth spending some time on. There is nothing wrong with funds that use leverage, but a leveraged fund is riskier than an un-leveraged fund that invests in the same assets.
This book does the best job that I have encountered of giving an overview of the universe of investment options available to income investors. In the years since this book was written, there have been a number of changes in the investing landscape that are worth understanding. First and foremost, the emergence of ETFs as a major presence has resulted in drastically higher transparency across a range of asset classes. While Phil and Ben were limited to looking at historical data on the risk characteristics of income generating asset classes, we can now directly measure the risk of long-term bonds vs. short-term bonds and junk bonds vs. investment-grade corporate bonds. The ability to directly compare yield to current risk levels in specific funds has a major impact on our ability to build income-oriented portfolios. For example, while MLPs and high-yield bonds are risky asset classes, their risk levels have become low enough relative to their yields to make them attractive for even fairly large allocations in an income portfolio (depending on your risk tolerance, of course). The ability to compare the risk measures vs. yields for specific assets provides the potential for a substantial improvement in the construction of income portfolios. These data were not readily available back in 2005, however.
In retrospect, the biggest lesson of the crash years with respect to income-generating assets is how critical it is to be able to measure risk. In the years around 2005, some of the highest-yield stocks were those of financial firms. Some income-focused funds (such as the $8.5 Billion iShares Dow Jones Select Dividend Index fund, DVY) were over-weight in financials for this reason and suffered as a consequence in 2007-2009 relative to the broader stock market.
In short, this book remains a very useful introduction and general reference on income investing. I highly recommend it to investors who want to understand the range of asset classes and strategies that can provide meaningful income. This pursuit has never been more crucial, given the historically low yields on Treasury bonds in the current environment, and the Fed’s commitment to keeping them low.
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