DEFLATION ALSO HITS INVESTORS / BARRON´S ( RECOMMENDED READING )

Friday, August 28, 2009

UP AND DOWN WALL STREET DAILY

Deflation Also Hits Investors


By RANDALL W. FORSYTH

Dividend and interest income fall with asset values; a forced dash from cash.

DEFLATION NOT ONLY IS HITTING prices and wage earners but also investors' incomes.

Even as the value of their assets have declined, the income they generate has fallen in tandem. That's different from bear markets of recent decades. Then, even if the paper value on investors' quarterly statement was down, at least they were cushioned by stable or even rising interest and dividend income.

Although the caricature is of a Park Avenue dowager clipping her bond coupons and cashing her dividend checks, middle class Americans depend on their investment earnings.

That's especially true of retirees. Not only do they face the likelihood of no increase in Social Security checks next year and 2011, they have seen the income from their retirement nest egg shrivel. Given their spending, which obviously is tilted heavily to relentlessly rising health-care expenses, they don't benefit from the plunge in other prices, such as for personal computers.

Meantime, they have suffered a significant income reduction. Consider a widow left with $500,000. She might have earned $20,000 from 4% certificates of deposit issued last year by troubled (but federally insured) banks. When they mature, she'll be lucky to get 1%. That translates to a $15,000 income cut, which likely translates to some serious belt-tightening.

At a 4% yield, she could have drawn down her nest egg by $35,375 a year for 20 years. At a 1% yield, her annual draw would have to shrink by nearly $8,000 a year, to $27,433. If she maintained her $35,000 rate of withdrawal, her nest egg would be depleted five years earlier if she earned 1% instead of 4%.

The impact isn't restricted to retirees. It also hits non-profit organizations such as charities and churches. Very few of them are big or sophisticated enough to invest with hedge funds and the like. Combined with the decline in contributions because benefactors' dire straits, the loss in investment income translates to cutbacks in their good works.

Overall, interest income by June was running at a 4% lower rate than for 2008, which equals a $50 billion hit to Americans' incomes. Dividends are down even more sharply, at an annual rate in June that was 25% below last year's pace. In dollar terms, the reduction was $170 billion from shrunken dividend checks. (These data come from the Bureau of Economic Analysis' personal income numbers through June, the most recent numbers available at this writing.)

Looking at just the Standard & Poor's 500 stocks, shareholders will receive $29.6 billion less through July than a year ago, reports Barron's doyenne of dividends, Shirley Lazo. A year from now, the reduction will be more than twice as big, some $61.2 billion less than the 2008 levels, according to an S&P projection.

That should be taken in the context of the $6.5 trillion loss to wealth from the decline in U.S. stocks since the October 2007 highs, based on the Wilshire 5000, the broadest measure of the U.S. equity market. And that's after the $4.5 trillion gain in stock wealth since the March lows.

This has been the downside of the Federal Reserve's policy to slash interest rates to near zero. It also is the effect of Corporate America's deleveraging, especially in the banking sector, which used to offer the highest dividend yields and were the favorite of equity-income funds.

No wonder that bond mutual funds have seen a gusher of inflows from investors looking for higher income as their money-market fund and CD yields collapsed. According to Investment Company Institute data, bond funds drew $29 billion in June, the most recent month for which numbers are available. In the latest 12 months, their take was $70 billion, according to Bianco Research's tally of ICI data.

Much of that went to investment-grade and junk corporate-bond funds, which last year were trading as if the Great Depression 2.0 was upon us. Given that fiscal and monetary policy were arrayed to prevent that outcome, they were great buys.

So far this year, the SPDR Barclays Capital High Yield Bond exchange traded fund (ticker: JNK), has vastly outperformed the Standard & Poor's 500 SPDR (SPY), 22.66% to 15.92%, according to Morningstar. Meanwhile, the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) returned 6.32%; over the last 12 months, its return of 9.23% trounced the junk ETF (minus 1.13%) or the S&P Spyders (minus 18.09%.)

That leaves the widow with a practical problem: while cash yields are near zero, riskier fixed-income assets have rallied massively and no longer offer nearly as compelling yields. She is left with no choice but to extend maturities to increase yield, even though that poses risks in terms of possible future rate rises and also the worsening default rates that lie ahead.

That said, she is left with a conundrum. No longer do corporate credit offer such compelling values (yield spreads are roughly back to where they stood prior to Lehman Brothers' collapse last September.) But the easy, risk-free choice earns bupkus.

Some intermediate-term bond funds provide returns similar to CDs of yore with relatively modest (but not zero) risk. Among them is Sit US Government Securities Fund (SNGVX), which Morningstar has accorded its highest, five-star rating.

Still, there's no easy way out for those who depend on their investments for living expenses


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