Forget Bonds — Buy These 6% Yielders Instead

With its constant ups and downs, investing in stocks is like a roller-coaster ride. Investing in bonds, on the other hand, usually isn’t — especially during the bond bull market of the past 15 years. 

While bond investors love to complain about the pitifully small income stream bonds provide these days, they’ve grown accustomed to growing and stable principal values. But that era of good feelings is probably over. Bull markets ALWAYS come to an end — and it appears this time is no different. 

As the Federal Reserve telegraphed its “tapering” plans and even hinted at higher federal funds rates, the bond market responded accordingly: It went down. This price chart of the iShares Barclays 20+ Year Treasury Bond Fund ETF (NYSE: TLT) paints a clear picture.

#-ad_banner-#At the height of “Taper terror,” shares plunged over 15%. Prices have recovered, but don’t expect a quick return to the bond glory days. If anything, investors should prepare for more volatility.

The challenge that investors face daily is the need for income and some type of bond or bondlike allocation to a portfolio. For example, as an investment professional, I manage a handful of different investment strategies — among them a balanced strategy. A balanced strategy requires a mix of both stocks and bonds; the ratio will depend on what market conditions dictate. Currently, my mix stands at roughly 75% stocks and 25% bonds. 

But I’m constantly tasked with finding conservative investments that also provide a decent income stream for that allocation sleeve. The slowly deflating bond bubble not only presents risk to principal value, the lack of quality income is almost laughable. About six months ago, I profiled two preferred-stock exchange-traded funds (ETFs) that solve this problem. Here’s an update on both.

PowerShares Preferred Portfolio (NYSE: PGX): Since I profiled this stock in November, PGX shares have only risen about 4% versus TLT (the long Treasury ETF) which has gone up a little more than 5%. However, PGX pays a hefty 6.2% dividend yield, more than double TLT’s. One of PGX’s strongest traits is the quality of its portfolio: Over 60% of the preferred stocks in PGX’s basket are rated investment-grade. 

IShares S&P Preferred Stock Index Fund (NYSE: PFF): Shares of PFF have gone up a little more than 3.5%, thus offering a bit more upside than PGX and definitely TLT. One perceived weakness of PFF is the credit quality of its portfolio. Only 15% of the basket is considered investment-grade — but the trade-off is a higher yield: 6.6% in PFF’s case. 

Risks to Consider: The biggest risks facing PGX and PFF is the sector make up of their portfolios. Over 70% of the holding in each are issued by financial services companies, which are constantly under scrutiny from regulators and the markets. Another risk is that many issuers are retiring preferred stock debt. While diminishing supply in preferred issues can create uncertainty for the composition of preferred-stock ETFs, one positive outcome (at least in the near term) is that a shrinking supply will support prices, resulting in less volatility.

Action to Take –> Preferred-stock ETFs like PGX and PFF have fared much better than Treasury bond ETFs such as TLT. Based on better performance on the downside and the gains in yield, investors should consider both PFF and PGX as bond surrogates. With price stability and an average yield of 6.4%, investors should experience a little less volatility than comparable Treasury ETFs and have 10% or more total return potential — which is quite respectable for fixed-income investments in a declining bond market.

P.S. Great-yielding investments that have plenty of cash for dividend growth are the foundation for Amy Calistri’s “Daily Paycheck” investing strategy. To see how she’s used this strategy to earn $49,000 in dividend checks since 2010, click here.