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Home > Investing > Tired Of Low Interest Rates? Here’s An Alternative!

Tired Of Low Interest Rates? Here’s An Alternative!

February 21st, 2012 Leave a comment Go to comments

We live in a low interest rate environment. The U.S. Federal Reserve which has power on setting short term (as well as specific methods to influence long term rates) has made it clear that rates are going to stay low for at least 2 years, perhaps more when you consider that any increases will happen gradually.

This is unfortunate for a few reasons. The most obvious is that low short term rates don’t offer any rate of return. In fact you can make a case that the returns are negative. For example, the 10 year U.S. Treasury bond is yielding about 2% – which after a reasonable assumption of >2% inflation going forward leaves you with a negative real rate of return. How’s that for policy?

A far more damaging aspect of this policy is that it has distorted the relationship between stocks and bonds as a means of valuing the return and risk of investments. Are stocks really cheap now? Well, you can make the case that they are because the 10 year is at 2.0% – but, what would a real market bond rate be right now? Certainly higher than this rate. If it were at a higher rate this would make stocks less attractive.

There was a time when money was worth something – it isn’t now. Back in the 1980’s the great Fed chairman Paul Volker set interest rates that reflected the fiscal policy of the day – which was that Federal borrowing reduced money available in the private markets. Since the Federal Government was competing for money, making it less available to everyone else they paid higher interest rates. Today, money isn’t worth anything, it’s cheap and free.

To get more interest you are going to have to put your principal at risk. This is what the Fed policy is forcing you to do.

To make money in this environment you need to be creative to find investments. The investments I will provide today are not the typical options you might hear about. This is probably a good thing because who wants more competition! However, it takes time to learn and understand alternative kinds of investments to be comfortable enough to actually buy them, as I have found. This article will get you started.
I will follow up with another post that talks about how to buy these investments.

No Free Lunch

To make money with bond like investments, I’m going to first say that there isn’t any credible way to make high interest today that protects your principal. If you want to put cash away to keep the money as cash, you have a some options. The high interest rate options have some downsides.

So, what can you do? I have done my research and have put my own money in my portfolio in a class of investments that offer high coupon rates and conservative management. There are a number of reasons why they work which I will explain. Wall Street is starting to figure this out, but you still have an opportunity to get in on these investments.

The Investment: REIT Preferreds

The investment that I use to replicate a high yield money market account is Real Estate Investment Trust (REIT) preferreds. You may not know much about these because REIT’s are considered ‘alternative’ investments themselves. On top of this I use not the REIT common stocks but their preferred stock, which is an alternative investment in and of itself.

I talk a lot about preferreds on this site. They make up a big chunk of the bond part of my portfolio. Here are a few articles about them:

Intro To Preferred Stocks

How Preferred Stocks Differ From Bonds

Investor Repression: My Preferred Stock Was Called

In summary, preferred stocks are bond like investments that trade like stocks. They are designed to be a stable value of interest income, but they are priced to market every day so they can both trade a prices higher and lower than their par value.

There are a confluence of factors that together make REIT preferreds great alternatives to money market accounts and other cash like investments.

Large Debt Needs

High quality publicly traded companies mostly don’t need to issue debt – they are self funding by the growth of the business. REIT’s by their business model – managing real estate – require lots of capital that is issued either thru equity or debt offerings. This isn’t a knock against them, this is their business model. So, naturally by their business model they have debt to invest in.

Credit/Company Management Rating Discrepancy

In a typical credit situation, the credit risk largely determines interest rates. But which credit risk? If Microsoft is issuing debt, the credit quality is determined by the business itself: return on investment, balance sheet, cash flow, etc. In the case of REIT’s the credit quality is determined not by the quality of the management or the business, but the quality of the real estate itself and by association the tenants.

The REIT business management doesn’t factor in at all. So, while Realty Income (O) has excellent management as does Boston Properties (BXP), BXP gets a much higher credit rating because they own “premier” real estate – locations that are always desirable, while O owns primarily cookie cutter retail real estate across the country.

If you are an equity investor you might want to buy BXP over O since the real estate should offer higher returns because the high quality real estate should increase in value more over time. But remember we are looking for interest not capital gains. From this point of view the lower credit quality of Realty Income gives us the opportunity to earn higher interest while still getting great management.

Long Term Net Leases Provide Stability

Many REITs use so-called triple net leasing. This type of leasing locks the tenant into long term contracts, 10, 20 or more years. This type of contract provides stability for the REIT and consistent revenue to pay interest on debt. Tenants do go bankrupt which can harm these contracts, however, even bankrupt tenants don’t close all their locations. High quality REITs have been able to manage tenant issues first by selecting good locations in the first place, as well as making adjustments as required. The REITs I have selected have a track record of managing their business well through booms, recessions as well as tenant bankruptcies.

The Company List

These are the REITs that I have selected. There are probably others that could be suitable candidates. This table below will give you a summary of how they have performed over the past regarding common stock dividends. Preferred stocks dividends are higher on the totem pole, meaning that they get paid first before any common stock dividends can be paid. So, given the history of these companies, it’s a good bet that their preferreds will continue to pay.

Company (Symbol) Years Dividend Paid Streak Of Dividend Raises (years)
Realty Income(O) 43* 18
National Retail Properties (NNN) 28 22
Health Care REIT (HCN) 40 8
* – 25 years as a private company

The Preferred Stock List

These are the specific REIT preferreds that I have selected. The coupon yield is quoted at par price. Since these preferreds typically trade at above par price, the actual yield you will get will be lower depending on what the price you pay is.

Company (Symbol) Coupon Yield Par Value Recent Market Price
Realty Income E Series (O-E) 6.75% 25.00 25.15
Realty Income E Series (O-F) 6.625% 25.00 25.00
National Retail Properties D Series (NNN-D) 6.625% 25.00 25.00
Health Care REIT D series (HCN-D) 7.875% 25.00 26.02

Summary

Wall Street offers preferred investments that trade like stocks but designed to provide bond like returns. Because these investments are not government backed nor based upon typical credit requirements that come with typical corporate bond offerings, they offer higher yields to compensate for perceived risk. However, when you stick with high quality REITs with excellent management you get an opportunity to get a great yield with lower risk.

Look for a future post on how to buy these securities and what to expect when you own them.

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  1. February 21st, 2012 at 11:27 | #1

    Definitely a good idea to add relatively stable income when rates are so low. Best part is it isn’t very complicated for individual owners to own these.

  2. March 1st, 2012 at 14:34 | #2

    This negative rate of real return is screwing over the common man, don’t you think? Not everyone has the expertise or inclination to become a savvy individual investor.

  3. March 3rd, 2012 at 13:23 | #3

    FG, well in a word yes. With the exception of people like Volker, there isn’t anyone out there who will take a principled approach. With the printing of money the Fed will simply take your money through inflation versus an approach that values money. The saver gets screwed to make way for the debtors.

    The way out is to own assets that have real value such as gold, stocks, real estate.

  4. March 3rd, 2012 at 13:25 | #4

    MC, thanks for stopping by. These are easy to own but still require some effort to learn about them. I would hope that investment brokers would tell their clients about them.

  1. February 25th, 2012 at 08:15 | #1