Why Income Investors Should Pursue Alternative Income Strategies

Whatever is left of the baby boom generation’s retirement is about to get wiped out. It’s the third and final step in the systematic destruction of a whole generation’s wealth.

OK, bold statement… we agree. But hear us out.

The first step came with the dot-com crash. Retirement accounts stuffed with tech stocks pumped by CNBC – or funds that bought tech stocks pumped by CNBC – were vaporized.

Boomers picked themselves up, dusted themselves off and a few years later they figured they were riding high again. Yes, their retirement accounts were a shadow of their former selves… but their homes were rising in value 10% a year, every year. So who complained?

Phase 2. Federal Reserve Chairman Alan Greenspan encouraged folks to load up on ARMs. His successor Ben Bernanke assured them there’d never been a sustained nationwide drop in home prices.

Bummer. We know how this one ended, too.

In their effort to “chase yield,” bankers on Wall Street created the Frankenstein known as mortgage-backed securities (MBS) and went on to insure them with the abominable credit default swap (CDS). That derivative stew poisoned the entire global financial system…

Now comes Phase 3. Baby boomers are approaching retirement age. What are you supposed to do with whatever wealth you have remaining? Why, unless you’re a speculator in stocks and commodities and willing to bet on monetary policy outcomes… you’re supposed to play it safe with fixed income, of course – first and foremost with US Treasuries.

A 10-year US Treasury note yields a paltry 2.95% this morning. Consumer prices, even using the government’s heavily gamed figures, grew 3.1% over the last 12 months.

In other words, if you lend your money to Uncle Sam in “safe” Treasuries, you lose all of your yield, and a bit of your principal, to inflation. It’s even worse if you opt for a savings vehicle like a bank CD. The best rate we find for a 5-year CD on the Internet this morning is 2.41%.

This is no accident. It’s policy. Even if, in the end, we discover it’s accidental policy. “Negative real interest rates” are how the federal government will try to pay down some of its staggering debt.

This puts income investors in a real pickle. Sure, they could turn to a corporate bond fund… but how wise is that when the economy is slowing and profits are bound to come in below Wall Street’s lofty expectations?

Of course, there are municipal bonds, and the tax advantages they bring. But at a time when municipal budgets are strained and whole cities in California are filing for bankruptcy… how “safe” is that?

Income investors need to throw out the traditional playbook… and pursue alternative income strategies.

For instance, did you know you could take a humble corporate bond yielding 7%… collect a yield of 10%… and cash out a 73% gain? And all without adding risk or leverage?

“Let’s say Company X is expanding its business,” says our income specialist Jim Nelson. “It plans to open 10 new retail stores for its widgets in the coming few years. To do so, it issues 5-year bonds, also called notes, with a 7% coupon rate.

“After the second year, the widget industry enters into a downturn. Sales growth slows, but the company is still cashing in steady cash flows. Since investors are worried about the company’s top line, they sell their bonds. Prices fall from their $1,000 par value to $700. This is where we step in.

“We run the math and discover that even with a business slowdown, the company will still be able to pay off its bondholders. With the recent sell-off, we are able to lock in an even-lower bond price.

“At $700, that 7% coupon rate actually pays 10% ($70 annual interest/$700 investment). Plus, in just three years, we’ll receive the full redemption price of $1,000.

“Paying semiannually, we’ll receive six $35 interest payments… totaling $210 for the three-year period. That brings our total return to $510. We put down only $700. So in three years, we cash in a 73% gain… or 24% annually.”

Your broker won’t tell you about this strategy… because there’s little in the way of fees to collect.

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning