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How to Beat Social Security’s Miserly 1.5% COLA

With just a 1.5% cost of living adjustment in Social Security benefits for 2014, income-focused clients are in for another frustrating year. Yes, it’s true that core consumer costs have been moderate recently but that doesn’t exactly mitigate the strain on folks living on a fixed income, as we’re about to head into year six when safe bank deposits will pay less than 1% and a five-year Treasury note yields about 1.5%. Meanwhile, the trailing 12 month yield for the SPDR S&P 500 ETF (SPY) is below 2% as even solid dividend growth can’t keep pace with surging price gains.

So what’s the strategy for clients in search of income? Well, before trawling among stocks, the out-of-favor bond world deserves another look. Yes, Treasuries have too low yields and too-high sensitivity to rate changes. But ever since last summer’s rate run up, high quality corporate bonds have better yields without any change in their risk profile. The Vanguard Intermediate Corporate Bond ETF (VCIT) and the iShares Credit Bond ETF (CFT) both have trailing 12 month yields about double the 1.5% Social Security COLA:

VCIT Dividend Yield (TTM) Chart

VCIT Dividend Yield (TTM) data by YCharts

Both ETFs are investment grade, and have current average durations of about 6 years.

The real value in the bond world, however, is over in municipal bonds. Yes, Detroit declared bankruptcy, and Puerto Rico -- a small percentage of many muni bond portfolios given its bond interest is exempt in every state -- has some serious fiscal issues. But those are not representative of the entire market. A well-diversified high-quality portfolio is well insulated from any permanent credit issues. As long as you’re willing to stay patient through intermittent market-wide bouts of volatility, there’s an unbeatable income opportunity.

The iShares National AMT-Free Muni Bond ETF (MUB), the largest muni ETF, has a trailing 12-month yield nearly double the Social Security COLA, and that’s before factoring in the taxable equivalent yield.

For clients in the 25% federal tax bracket the taxable equivalent yield is more than 3.5% these days. Investors in the 35% federal tax bracket are pocketing a 4.2% taxable equivalent yield; that’s nearly triple Social Security’s COLA for 2014.

The ETF is on the long side of the intermediate tranche with a current average duration of 7.2 years, which meant steeper price declines this past spring/summer during the rate climb. Year-to-date, iShares National AMT-Free Muni has lost about 2.5% year to date. That’s nothing to cheer, but a bit of perspective: if you’re investing in dividend-paying stocks for income, your potential downside in a crappy year is going to be a lot more than 2.5%. Keep in mind that the SPDR S&P Dividend ETF (SDY) lost 24% in 2008.

For an ETF with a more conservative yield curve approach, Pimco Intermediate Term Municipal ETF (MUNI) has a 5.4 year average duration and a 2.3% trailing 12 month yield. For clients in the 25% tax bracket that pushes the taxable equivalent yield to more than double the Social Security COLA. For someone in the 39.6% federal bracket that’s the equivalent of a 3.8% taxable yield, with limited downside given the tight leash on duration.

If you do want to generate COLA-beating income from the stock side of a portfolio, some careful use of equity research tools is required. Less than 20% of the S&P 500 stocks have trailing yields of at least 3%. And as you’d expect given investor thirst for income, plenty of the high yielders come with equally high valuations. This YCharts Stock Screener ranks the S&P 500 by dividend yield and includes trailing 12-month PE ratios for a first pass at valuation.

AT&T (T) the classic income stock looks enticing with a near 5% dividend yield, but a 25 PE ratio is a steep price to pay for that income. Same goes for a utility like PG&E (PCG). The dividend yield of more than 4% is eye catching, but a 20 PE ratio for a company where EBITDA and dividend growth are in the low single digits over the past five years isn’t an easy value proposition.

The tech sector is. Intel (INTC) has a dividend yield that is more than double the Social Security COLA and a cash-adjusted PE ratio of just 12x. Meanwhile, EBITDA has more than doubled and dividend growth has averaged double-digits over the past five years. With tech companies holding huge piles of cash, calculating PE ratio ex-cash can be helpful, and it's remarkable how cheap some tech stocks are on that basis.

Microsoft (MSFT) also has a 3%+ yield and its cash-adjusted PE ratio is hovering near 10x. EBITDA hasn’t been gangbusters, but it’s been far better than a pricier utility, and the dividend has more than doubled over the past five years.

Move over into the energy sector and there’s an even more compelling income/valuation story: Chevron (CVX) has a dividend yield above 3% and its cash-adjusted PE ratio is below 9x.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

Read more articles about: Investing Ideas  social security   dividends   income investing   bonds   

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