It’s not easy being a fixed income investor in today’s markets.

Record-low bond yields are making it difficult to earn much income these days. And the threat of higher interest rates and inflation ahead mean diminished value for your traditional fixed income holdings in the years to come.

That’s why now may be the right time to consider other investments that produce regular income, but can also offer some protection from rising rates. Let’s take a closer look at why you may want to consider a fresh approach to your fixed income portfolio …

In last week’s Banyan Market Letter, we pointed out that the “golden age” of bond investing is likely over. That heyday for bonds resulted in rich gains for investors over the last several decades as interest rates and inflation steadily declined.

But now, this scenario could reverse in the years ahead. Spiraling government debt levels will eventually lead to higher inflation and interest rates, in our view … it’s only a question of timing.

In this environment, investors at the longer end of the “yield curve” … those holding Treasury bond maturities of anywhere from 20 to 30 years for example … could experience NEGATIVE real returns, after adjusting for inflation.¹ In other words, despite investing in the safety of Treasury bonds, you would likely watch the buying power of your portfolio erode over time.

Some savvy investors aren’t waiting around for this to occur.

Bill Gross, manager of the world’s largest bond fund, created a stir recently by dumping ALL of his US Treasury bond holdings. He unloaded nearly $30 billion worth of Treasury and government agency debt in just one month.²

This is one early warning signal worth heeding. In fact, we’ve been recommending investors scale back on maturities above seven to 10 years for some time now — favoring the shorter end of the yield curve around the four-year mark instead.

We also believe most investors should look beyond more conventional bond holdings and consider adding some fixed income surrogates to their portfolios. We’re talking about specialty investments that could offer not only higher current income flows now, but over time a growing stream of income and capital appreciation potential.

To be clear: We’re NOT suggesting that you rush out and sell all of your bond holdings. After all, bonds can provide important benefits for your portfolio, including diversification and lowering your overall volatility if you also own stocks.

But as we pointed out last week, this could be an excellent time to review your income portfolio, with an eye toward possibly shortening your overall maturity, and considering bond surrogates where appropriate. When considering these alternatives, however, remember that specialty investments may have significantly different risk characteristics than bonds.

Treasury bond yields of 10 years or higher are hovering in the 3.5 to 4.5 percent range right now. However, many of the bond surrogates we’re investing in now offer yields between 4 and 8 percent … with some near 10 percent.

One of the specialized asset classes we use judiciously is master limited partnerships (MLPs). Select MLPs have been outperforming the stock market … bond market … even the commodity market in recent years. In some cases by a margin of almost 7-to-1!³

What’s Better Than Bonds?

US Treasury bonds are still considered one of the most secure investments on earth — backed by the full faith and credit of Uncle Sam. But investing in them means you’ll likely sacrifice yield in the process. And this involves taking on another risk … namely interest rate risk … or the risk of future inflation.

Historically, inflation has averaged about 3 percent annually, and it’s a good bet that it may head even higher over the next several years.⁴

Look at it this way; to beat today’s inflation rate you must go all the way out to a 10-year Treasury note yielding 3.4 percent now. But, you may not want to lock up your money for that long. After all, a lot can happen to interest rates and inflation over the next decade.⁵

If rates track higher, then your 10-year note is likely to depreciate in value over time. And if inflation rates surge higher, you’ll lose purchasing power to the rising cost of living, perhaps at a time you can least afford to.

Alternatives do exist, but you’ll need to do your homework because your income needs and tolerance for risk is unique to you.

One way we tackle interest rate, inflation and credit risks at Banyan Partners is by customizing a bond portfolio to meet each client’s needs. With the interest rate environment shifting, you’ll have to take a more opportunistic approach going forward.

We suggest that to preserve your wealth from inflation and boost your total returns in today’s challenging markets, you consider new alternatives:

Alternative #1: Some of the very best opportunities today aren’t even in US markets, but are found internationally. If you look beyond our borders, you’ll find many countries AND companies that are:

Healthier than the US economically … 

With stronger currencies than the US dollar … 

And offer higher interest rates than you can find in US markets.

In short, taking a more global approach to your investments could help you earn more income over the next few years.

Alternative #2: Another fixed income strategy is one we’ve termed “Dynamic Dividend Plays.” These are a small group of high-quality, high-yielding stocks we’ve selected. These companies have increased their dividends every year for a minimum of 25 years. In fact, one of these companies has paid consistent dividends each and every year since 1916!

For example, if you'd bought one of our dynamic dividend plays just 10 years ago, you could have already received one-third of your original purchase price back in dividends alone … PLUS your effective dividend yield would have doubled. That’s not including the capital gains you would also have received as the share price doubled in 10 years.⁶

Alternative #3: A handful of America's biggest energy companies benefit from a unique advantage: The US government gives the income they generate huge tax breaks. In exchange, these companies are required to pay out nearly all profits to shareholders in the form of annual dividends.

Barron's has said this asset class "could be the decade's quietest investment success." That’s because these companies have outperformed the S&P 500 by a margin of nearly 7-to-1 in total returns over the past 10 years on average.⁷

These fixed income surrogate investments may not be a good fit for every investor, but you owe it to yourself to take a closer look and decide for yourself. What you may find is an opportunity to boost your current income and enjoy growing yields in the years ahead.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. We’re working on a special report that offers much more detailed research and analysis about this important topic. Watch your inbox, because next week, we’ll invite you to download your copy as soon as it’s published, for FREE.

The investments discussed in this newsletter may not be appropriate for all investors. Investors must make their own decisions based on their specific investment objectives, risk tolerance, and financial circumstances. This report is solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

¹ FMRCo. (MARE): Bond investing when yields are low, 10/20/10
² Wall Street Journal: Pimco’s Gross Dumps Treasuries, 3/10/11
³ JPMorgan: Alerian MLP Index ETNs, 3/8/11
⁴ FMRCo (MARE) as of 4/15/09
⁵ Yahoo Finance, data as of 3/15/11
⁶ Standard & Poor’s, data as of 3/5/11
⁷ JPMorgan: Alerian MLP Index ETNs, 3/8/11