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How to Be Safely Diversified and Earn Hefty Yields

If you're not at all concerned about yield, diversified income investing is easy.

The market is full consumer goods companies offering 3-4% yields some of which have staggering records of dividend increases for 30, 40 or even 50 years.

Provided these companies are not overpriced, they make very good long-term "heirloom" investments since they are very nearly recession-proof. What's more, once companies like these have established a track record of dividend increases for several decades, they take pains to keep it.

But the truth is a 3-4% yield on its own simply doesn't cut it for most income-seeking investors.

In Ben Bernanke's rotten world, a few select high-yield investments are practically a necessity these days.

After all, if you are looking to establish a $100,000 income stream, you'd need nearly $3 million in principal if your yield is in the 3-4% range. For many income investors, it's just not enough.

The problem is once you start to look for companies with a 5% yield or better, the selection of investible companies becomes much more narrow.

And here's what I know about narrow: it tends to concentrate your investments in a few sectors, which can be risky.

The good news is this diversification problem can be overcome. Let me explain.

The Search for Attractive Yields

In today's market, there are two types of companies that offer attractive dividends in the 7-10% yield range. They are real estate investment trusts (REITs) and energy/resources master limited partnerships (MLPs).

Both these investments benefit from special tax treatment, which means they don't pay corporate tax, provided they pass their income through to investors as dividends.

Although they are tied to the real estate cycle in apartments, offices, warehouses or retail buildings, equity REITs make solid investments.

They're not to be confused with the high yielding mortgage REITs that currently benefit from the Ben Bernanke yield curve.

The largest of these are American Capital Agency Inc. (Nasdaq: AGNC) and Annaly Capital Management (NYSE:NLY) both of which pay yields in excess of 13%. They invest in long-term fixed rate mortgages and finance themselves in the short-term repo market.

That's a very dangerous game, which promises to blow up when interest rates eventually rise. So don't get fooled by those gigantic yields, stick the property REITs.

On the other hand, MLPs offer investors the chance to benefit from the resource extraction business, whether oil, gas or mining. MLPs routinely pay yields over 6%, with some into the double-digits.

The snag to watch here is that income stream for most of them is tied to a finite pool of assets, or will expire in a finite period of time.

Since your investment is essentially "on the clock" that means that what you see is not precisely what you get; you have to look closely under the hood.

In this case investors need to make sure the yield is high enough and the pool of assets or life of the company long enough to justify the overall investment.

Another sector that offers high dividend yields is shipping.

With a 9% yield, companies like Safe Bulkers (NYSE:SB) offer investors the return from a fleet of ships, operated as bulk carriers (in SB's case) or as tankers.

The problem here is that shipping is a highly cyclical business. It depends not only on world trade and the strength of the world economy, but also on the shipbuilding cycle. In good years, the world's shipyards all operate at full blast and produce too many ships for the amount of trade available which eventually weakens the shipping market.

Even More Ways to Spread the Risk

Income oriented investors are thus likely to end up with a portfolio heavily weighted in real estate, resource MLPs and shipping. That's a start but doesn't quite do the job.

They will have nothing in tech, little in emerging markets, and not much in consumer staples (which typically yield in the 3-4% range).

They may have a few investments in electric utilities which can yield above 7% if the market is depressed. But the wise investor will be careful here – utilities' returns often have a maximum, imposed by the local regulators, but no minimum. If storms, earthquakes or unusual costs hit, utility profits and dividends can be decimated.

To be properly diversified, investors should consider these two sectors as well.

One is the financial services sector, where a number of companies making mezzanine debt and equity investments pay good dividends – a typical example is BlackRock Kelso Capital Corporation (Nasdaq: BKCC) which yields over 10%.

Here investors need to avoid companies that dilute net asset value by frequent share issues, since the managers of such companies typically make their return on assets under management. A couple of insurance companies also pay good dividends and can from time to time be interesting.

The other source of diversification is the international funds sector. There are a number of closed-end funds, such as the Mexico Fund (NYSE:MXF) which pay out a substantial percentage in "dividends" each year.

Provided the market in which the fund invests is healthy, this can be a good way of boosting income, while offering exposure to an interesting international market -Mexico itself is currently attractive. While purists will argue that part of these dividends is paid from capital, they at least offer the investor a good cash flow from a source outside the real estate, energy and shipping sectors.

Finally, another approach to income investing is to mix the 7-12% dividend yields from real estate, MLPs and shipping with "heirloom" blue-chips from other sectors yielding 3-4%, giving a blended cash flow yield of perhaps 6%.

For the safety-conscious yield-seeker, this may be the best strategy of all.

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Join the conversation. Click here to jump to comments…

  1. Bob Willey | August 21, 2012

    Thank you, Martin Hutchinson.

  2. Simon Leach | August 21, 2012

    First THANK YOU. The decimation of American savings thanks to the "stimulus" of the economy is a story that I believe is woefully under covered. I rarely speak to an investor where yield without undue levels of risk are not a primary concern. But there is a major asset class that you did not mention Consumer Credit. In turns out that one of the best investments Americans can make is investing in their fellow Americans!

    The secret is that the vast majority of Americans pay their bills and when they borrow money 95% will pay their debt. Peer to peer lending is remarkably sophisticated and fractionalizes ownership of loans. One small 10,000 loan may have 100 investors taking small pieces. Over $75M (6,000 loans)originated last month and the industry is growing 10% every month means even investors with relatively small means can build portfolios with enough diversification to get very predictable returns in the 8% – 10% range. Best of all capital turns quickly because these are fully amortizing 3 year loans.

  3. Joe Wenzel | August 24, 2012

    While you make some good points, I have some concerns about companies that make mezzanine debt and equity investments. I invested in American Capital Ltd (ACAS) before the market tanked in 2008. Yes I was getting good income, however, this stock still has not recvoered to anywhere near pre crash levels. it was in the $45 to $510 range, now it is at $11. I have kept the investment in the hope that they would resume paying out income, but that has not happened yet. Some other companies have recovered, so this is not intended to be a commentary on all companies of this type.

  4. DEAN NEHRIG | September 13, 2012


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