By Jason Zweig | 6:09 pm ET July 12, 2013
Image Credit: Christophe Vorlet
With Federal Reserve Chairman Ben Bernanke signaling again this week that interest rates are likely to stay at rock-bottom for the foreseeable future, where can you turn for even a trickle of investment income?
Just as the removal of oxygen from a room can make you lightheaded, artificially low interest rates could make some income-oriented investors lose their ability to think clearly. Those who want ample income must either wait patiently until rates finally rise—or must violate the rule of thumb that says you never should fund income needs by dipping into capital. Above all, you must be skeptical of anything that purports to offer high current yields.
I was recently contacted by a reader whose father’s proposed strategy has him concerned. The father, in his early 80s, is a semiretired science professor at a leading university on the East Coast. He owns the family’s 200-year-old ancestral home, which he wants to maintain for posterity. But the property is expensive to maintain, requiring perhaps $50,000 in annual upkeep.
So the professor, taking advantage of low interest rates, has borrowed several hundred thousand dollars on the property at roughly 4%. He figures he need only find a few investments with high yields to come out ahead, reports his son.
But how easy is that?
The professor has found three funds from Nuveen Investments that he thinks might fill the bill: the Dow 30 Enhanced Premium Income Fund, the Nuveen Equity Premium & Growth Fund and the Nuveen Equity Premium Opportunity Fund.
These are closed-end funds—mutual-fund-like portfolios that trade on an exchange as if they were individual stocks. According to Morningstar, 31 such funds, with some $19 billion in assets, follow a strategy of writing “covered call options” on their stock holdings—essentially selling to other investors the right to buy those stocks at a certain price. Selling the options generates income for the funds’ investors—yields that run 6.7% to 8.3% at the funds the professor is interested in.
But those fat yields aren’t a free lunch. These three funds charge 0.91% to 0.98% in annual expenses, or up to $98 on a $10,000 investment, roughly 10 times the cost of an index fund. At two of the three, yields have fallen by about one-third since 2007. Forecasting future yields on such portfolios is “an art, not a science,” says fund analyst Mariana Bush of Wells Fargo Advisors.
“We try to provide a predictable cash flow to our shareholders,” says Dave Lamb, a senior vice president at Nuveen, which sponsors the three funds, “but there are times when we’ll have to change.”
Because closed-end funds trade on an exchange, their share prices are set by the whims of the market as well as the value of their underlying assets. Closed-ends can trade for more than their assets are worth (a premium) or less (a discount). These three funds traded this past week at discounts of 4% to 7%, but in late 2008 they sank 13% to 20% below what their portfolios were worth, Morningstar says.
Covered calls are “not a protection strategy,” says Robert Gordon, president of Twenty-First Securities, a brokerage firm in New York. “You earn extra income, but you still have the downside of a stock, and you’ve limited your upside.”
Reframing the income problem could help. Almost universally, investors think of their money in two buckets: income, or the cash thrown off by a portfolio, and principal, or the underlying portfolio itself.
Most investors regard dipping into principal as almost a crime. They fear that if they tap into principal even once, they will end up completely draining it.
Segregating income and principal into different buckets also enables investors to put a gloss on their own performance: In a bull market, they savor the income from dividends as a discrete gain; when stocks fall, the dividend income feels like a separate consolation.
But there is no logical reason why you can’t manufacture your own dividends, and that is probably what the professor and many other investors should consider. Rather than taking income only from dividends or interest, you could selectively harvest gains from your stock portfolio.
Trim your winners or the stocks you think are fully valued, consulting your accountant to ensure those withdrawals will be taxed as long-term capital gains. If you withdraw 1% or less per quarter, a diversified stock portfolio should come within spitting distance of maintaining its value, after inflation, in the long run.
Such a plan has the added benefit of automatically reducing your exposure to stocks, which should provide conservative investors some comfort as the stock market teeters at all-time highs. When the markets won’t yield, your best option might be to generate the yield yourself.
Source: The Wall Street Journal