5 Commandments for Income Investors

03/09/2011 10:48 am EST

Focus: BONDS

Carla Pasternak

Editor, The Income Investor

The road less traveled is far more likely to lead to a rich payout stream, writes Carla Pasternak, editor of Dividend Opportunities.

1. Look Off the Beaten Path Always remember that yield is a combination of dividends paid and share price. If prices rise, the yield on a security falls, all else being equal.

So what will happen to many of the most popular high-yield spots if millions more investors are looking for solid income? Their prices would likely rise, pushing yields down.

That's why I think it's valuable to look off the beaten path for higher yields. You have to look into the special classes of securities built for income investors, including business development companies, stapled products, master limited partnerships and even exchange-traded bonds.

Here is where you'll uncover truly mouth-watering yields overlooked by the majority of investors who are focused on common stocks.

2. Dividend Safety Is Key
For us income investors, nothing should be held in higher esteem than the safety of our dividends. After all, what's the use of a high dividend if it's only going to be cut a few weeks later?

But an amazing thing happens when you follow my first tip and look off the beaten path for income investments.

Common stocks are under no obligation to pay a dividend; they can cut their payments at any time if they please. But some securities—such as preferred stocks—can't change or reduce their payments.

A number of other little-known securities have the same restrictions, all but guaranteeing you'll be paid a stream of income you can count on.

NEXT: How to Find Higher Yields


3. Use Market Downturns to Find Higher Yields
Most investors look at a market downturn as a bad thing, and in fact, I would rather the market rise than fall. But I also appreciate the opportunities that appear in a downturn.

As I said, a stock's yield is a function of its price. If a stock pays $1 a share in dividends and trades at $20, its yield is 5%. If the same stock dips to $10 a share, the yield has risen to 10%.

That's one reason I bought heavily during the recent market downturn—the yields became too high to ignore! If you can stomach volatility during a bear market, you'll likely have a chance to lock in unnaturally high yields.

4. Don't Be Afraid to Take a Loss
Subscribers always ask me when to sell their holdings. And for good reason—when you sell is just as important as when you buy.

I'm personally never afraid to take a loss. Many investors continue to hold losing stocks, hoping for a rebound—only to watch them sink further. I've seen this countless times, so I'm always sure to look at the reasons a holding is falling, and whether I should sell.

If the stock is falling with the market, I may not be worried. However, if a change in the company's operations means it could see rocky times ahead, I don't want a part of it.

5. Taxes Matter
When is a lower yield more attractive than a higher yield that's just as safe? When the lower yield is taxed at a lower rate.

Consider this: An investor in the top federal tax bracket is invested in a municipal bond that pays 6%. Because the income from this bond is tax-free, the taxable-equivalent yield is actually 9.2%! In other words, if the same investment were in a fully taxable security, the investor would have to earn 9.2% to have the same income after taxes.

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