What's an Income Investor to Do?

Investing used to be a lot less complicated, especially for those who needed to draw an income from their portfolios. Not so many years ago, back when everyone extolled the virtues of the long-term 10% average return on stocks, you could get more than halfway to that double-digit percentage return just by picking a variety of government bonds or bank certificates of deposit. Even if you couldn't decide what to do with your money, doing some shopping to find the best cash savings account would give up 4% or 5%.

But the days of easy income investing are over, at least for the moment. Market Rates Insight reported last week that rates on five-year CDs fell below 1% for the first time in history. With inflation rates running well above that figure, CDs, Treasury bonds, and most other traditional income-paying investments simply don't pay enough even to hold their real after-inflation value, let alone help you improve the purchasing power of your assets. As a result, millions of investors are asking themselves: What should they do to enhance their income?

Disappearing income
When you look at your alternatives, you can see that throughout the income-investment world, it's tough to find the income levels that many people need. Consider just a few:

  • When it comes to ultra-safe investments, CDs aren't the only asset having trouble. Even with the recent rise in Treasury bond rates, five-year Treasuries pay only 0.8%. You have to go well beyond 10-year maturities to get returns above 2% -- and even those rates won't cover the effect of inflation.

  • Explicitly looking for inflation protection is equally fruitless for income investors. Treasury protected inflation securities, better known as TIPS, have negative yields until you go close to 20 years out. And unless you hold them in an IRA or other tax-favored account, those returns don't even reflect the impact of taxes on your overall return.

  • Municipal bonds trade roughly in line with Treasuries. Yet although they have the added benefit of being free of federal income tax, they also have arguably higher default risk, as recent episodes of municipal bankruptcies around the country have raised some concerns about whether bondholders will get repaid in full when their bonds mature.

  • Among bonds, only corporates give you anything resembling a decent return. But to get a good yield, you have to be comfortable taking on a decent amount of default risk.

The failure of bonds to pay decent income has pushed many investors to stocks. But even among some popular dividend-paying stocks, payouts have fallen recently. Popular mortgage REITSChimera Investment (NYS: CIM) and Annaly Capital (NYS: NLY) have both made multiple dividend cuts in the past couple of years, as spreads between the amount they're able to earn on their mortgage-bond investments and what they pay on their short-term borrowings contract mildly.

The only place where income is rising
By contrast, the slowing economy has led a number of former growth companies to raise their dividends. Just last week, Cisco Systems (NAS: CSCO) raised its dividend by 75%, joining the growing crowd of tech stocks paying yields of 3% or more. Seagate Technology (NAS: STX) just hiked its payout again, making its quarterly dividend more than triple what it was less than five years ago. And of course, Apple (NAS: AAPL) just paid its first dividend since 1995.

On one hand, this is good news for income investors. With tech stocks now paying more in dividends than any other sector of the market, you can no longer point at tech as an anomaly against shareholders seeking income.

But if these companies are giving up on producing further growth from their capital, it may bode ill for the sustainability of stock market advances over the long haul. After all, it usually takes capital for a company to grow, and so if a company voluntarily gives up its capital by paying a dividend, it signals a turning point in its growth cycle.

Watch out
At this point, many investors have little choice but to accept the risk that dividend stocks involve. But although dividends are in vogue now, income investors should watch carefully to make sure that they don't take on more risk than they can truly handle -- especially if conditions in the stock market start to deteriorate.

Dividends are a key way to earn income, but they're not the only way to a successful retirement. We've got some ideas on how you can invest for the long haul in the Motley Fool's special report on stocks that will help you retire rich. Get your free copy today while it lasts!

Also, Apple's got a lot more going for it than just its new dividend. Get the whole story from our top tech analysts with their views on Apple.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter@DanCaplinger.

The article What's an Income Investor to Do? originally appeared on Fool.com.

Fool contributorDan Caplingeris fortunate enough not to need much income from his portfolio at the moment. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital, Cisco Systems, and Apple.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool'sdisclosure policyalways pays dividends.

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