5 offbeat ways to generate market-beating yields

Investors don't have to settle for low returns -- if they're willing to do a little homework.

By StreetAuthority May 21, 2013 2:59PM
Stock market report copyright CorbisBy Carla Pasternak                                                 

Interest rates near zero and record-low U.S. Treasury yields make finding good income investments a bit harder these days.

Don't get me wrong -- it's still possible to find attractive yields, but you need to know where to look. Some of my best ideas have come  when I veered off the beaten path and looked at asset classes overlooked by others. For example, I've locked in nice returns in the past by adding offbeat securities such as bank loan funds, trust preferred shares and master limited partnerships to my portfolios.

And luckily for income investors, I'm still finding plenty of fertile hunting grounds out there. To give you an idea, I've put together a quick summary of five spots where you can still find double-digit yields.

10% Idea No. 1: Business development companies
Business development companies, or BDCs, are a dream come true for high-yield investors. Many of these companies -- such as THL Credit (TCRD) -- yield at least 8%, and share prices are soaring.

BDC yields are powered by making loans to small companies and passing along the earned income as distributions. They are similar to private equity funds, giving retail investors the ability to profit from an area normally reserved for only the biggest investors. With bank credit still tight, BDCs are thriving as businesses have fewer options for financing.

Like real estate investment trusts (REITs), BDCs must pay out at least 90% of their net investment income as dividends to avoid paying income taxes. That's why they can carry high yields. If you want to invest, look for business development companies that consistently raise dividends (or at least hold them steady) and can cover their dividend with investment income.

10% Idea No. 2: Municipal bond funds
When is a 7% yield really 10%?

Answer: When it comes courtesy of a municipal bond fund.

Municipal bonds, or "munis," are bonds issued by state and local governments to fund highways, hospitals and other public projects. What makes munis (and the funds that hold them) attractive is that the interest they pay is exempt from federal income taxes, and sometimes state and local taxes too if the bond is issued by your local government.

You'll be hard-pressed to find a muni bond fund that pays more than 10% as a headline yield. But what you should look at is the fund's taxable equivalent yield, which can exceed 10% for muni funds like Pioneer Municipal High Income (MHI). The taxable equivalent yield is the yield you would need from a taxable investment (like a corporate bond) to match the tax-exempt muni yield.

To figure your tax-equivalent yield, simply divide the bond fund yield by 1 minus your marginal tax rate. For instance, MHI is yielding 7.1%; if you're in the 28% tax bracket, your taxable equivalent yield would be about 10%.

You can buy individual muni bonds, but funds are a better choice for most investors since they offer instant diversification. Even better, most of them pay monthly dividends.
10% Idea No. 3: Rural telecoms
Interest in telecoms is mostly confined to the major companies like AT&T (T) and Verizon (VZ), but I've found rich yields and a compelling story in a largely ignored part of the telecom sector -- rural landline phone companies.

These quaint relics of an earlier age throw off huge cash flows and pay healthy dividends. Some, such as Frontier Communications (FTR), have yielded up to 14% at some points during the past few years (the yield is now around 9%). But beware, they may be prone to dividend cuts, as has been the case with Frontier.

The rural areas these companies serve are too small to interest the big cable and wireless companies. As a result, there is little price competition. You might expect their revenue to be shrinking, but that's not the case. The reason is broadband Internet service. Yes, customers are shedding landlines in favor of cellular service, but they are also signing up for broadband. For most of these companies, broadband is only a tiny fraction of their revenue base, so there are still plenty of growth opportunities.

10% Idea No. 4" High-yield "junk" bonds
Junk bonds may sound like something for the recycling bin, but these investments can be safer than many stocks in one important way. If you own a junk bond and the issuing company goes into default, you are in line to be repaid before any of the common or preferred stock holders.

The key to junk bond investing is understanding bond ratings. Anything Standard & Poor's rates BB+ or lower is considered sub-investment grade, or junk. But despite their name, these bonds may be less risky than you think. During the credit crisis, junk bond default rates peaked at 12.9% but have since come down dramatically. According to ratings service Moody's, default rates on junk bonds fell below 3% in the fourth quarter of 2012.

The safest way to invest is with a junk bond fund. Like the muni bond funds discussed above, these funds offer diversification across companies and industries. And they also offer some nice yields -- the SPDR Barclays Capital High Yield Bond ETF (JNK) currently yields around 7.5%.

One note of caution: most bonds have seen a sharp run-up lately. To make sure you don't overpay, check the net asset value of any fund and compare it with the share price before purchasing. These bonds generally trade near 90% of their face value, but some funds now trade above net asset value.

10% Idea No. 5: Canadian REITs
Canada's strong property market allows these often-overlooked REITs to pay generous distributions and healthy yields. Canadian REITs such as Dundee REIT (D-UN.TO) carry yields above 6% and pay monthly.

Unlike U.S. real estate, which only recently began showing signs of recovery, Canada's property market is thriving. Occupancies are high, and moreover, Canadian REITs have been taking full advantage of low interest rates to refinance their debt.

And don't worry about buying Canadian securities. Most U.S. brokers can fill orders on the Toronto Stock Exchange (TSX). Fidelity, E-Trade and Schwab all offer access. Buying Canadian shares can actually be as simple as buying those in the United States. At worst, it might take an extra phone call to your broker to tap into the double-digit yields.

Action to take: The ideas mentioned above are just to get you started. The main thing to remember is that in a low interest rate world, you don't have to settle for low yields -- you just need to do your homework, and get a little creative.

Carla Pasternak does not personally hold positions in any securities mentioned in this article. 
StreetAuthority LLC owns shares of NYSE:T, NYSE:VZ in one or more of its "real money" portfolios.

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