The Magnificent 7: Current Income Strategies

In today's difficult yield environment, many investors are taking a diversified approach to income investing--drawing on a wide range of bond sectors as well as income-generating equities. Here are 7 key income strategies whose rewards and risks are worth examining now:

  • High yield bonds

    High yield bonds offer attractive income potential and have a long history of generating solid total returns. While they carry a higher risk of default, they have historically had a relatively low correlation to the broad fixed-income market and a negative correlation with U.S. Treasuries.

    Nearly 5 times the yield1

    Yield Comparison of US Treasuries and US Corporate High Yield: Mar 2003 – Mar 2013

    High yield bonds

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Emerging market debt

    The developing world offers attractive opportunities among both sovereign and corporate issuers. Indeed, emerging market debt can offer high levels of current income and the potential for enhanced total return as well as unique diversification opportunities.

    Opportunities may be available in EM debt markets2

    Yield Comparison of US Treasuries and US Corporate High Yield: Mar 2003–Mar 2013

    Emerging market debt

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Non-Treasury investment-grade

    Mortgage-backed securities (MBS), agency securities and high-quality corporate bonds may also be logical places to seek a better than Treasury yields without taking on as much additional credit risk as in the high yield and emerging sectors.

    Higher quality corporate bonds offer a yield advantage over Treasuries3

    US Treasuries vs US investment grade corporates

    Non-Treasury investment-grade

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Municipal bonds

    The municipal sector currently offers attractive yields relative to Treasuries. However, the market has changed dramatically over the past few years and uncovering value now requires the same analytical rigor that has historically been applied to other spread4, or non-Treasury sectors.

    Muni yields: a substantial premium over Treasuries5

    Municipal yield spread to US Treasuries: April 1993 – March 2013

    Municipal bonds

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Blue-chip stocks

    Many large, high-quality corporate stocks currently offer the best yields relative to U.S. Treasuries in over 50 years, and the potential for dividend growth offers an element of inflation protection that is unavailable from fixed-income. Companies have also been raising dividends lately, and with high levels of cash on their balance sheets, many corporations should be in good financial shape to keep increasing payouts.

    Yielding more with room to grow6

    Comparative yields: stocks vs Treasuries

    Blue-chip stocks

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Small cap stocks

    Although it's not widely appreciated, there's a large group of small companies in the U.S. paying very respectable dividends. In fact there's more small companies offering dividend yields above 3% than large; and the number outside of the U.S. is even larger.

    Dividends are not just for large cap investors7

    # of small cap companies with 12 month dividends grouped by yield

    Small cap stocks

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

  • Alternative equity income

    Investors are seeking new sources of income in today's yield-starved world, for example: an allocation to Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs). In addition to the potential high current income, MLPs and REITs tend to exhibit a lower correlation to the overall stock market and can therefore serve as a good source of portfolio diversification.

    The ABCs of MLPs & REITs - a lesson in Y-I-E-L-D8

    Current yields by asset class

    Alternative equity income

    Source: Bloomberg, as of 3/31/2013. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Investors cannot invest directly in an index and that unmanaged index returns do not reflect any fees, expenses or sales charges.

    See Important Information Section for additional information and risks.

High yield bonds
Emerging market debt
Non-Treasury investment-grade
Municipal bonds
Blue-chip stocks
Small cap stocks
Alternative equity income
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Important information
1 – US Treasuries (UST) are represented by the Barclays US Treasury Index. US High Yield (US HY) is represented by the Barclays US Corporate High Yield Index. Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government index. The Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt, including corporate and non-corporate sectors. Please note that an investor cannot invest directly in an index.

2 – US bond yields represented by the Barclays U.S. Aggregate Bond Index, which is an unmanaged index of U.S. investment-grade fixed-income securities. EM sovereign bonds represented by the JPM EMBI+ Sovereign Index, which tracks U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities. EM high quality corporate represented by the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Investment Grade (IG), which is the investment grade component of the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad. Investment grade refers to a credit quality rating of BBB or higher. EM high yield corporate represented by the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Below-Investment Grade (IG), which is the below investment grade component of the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad. Below-investment grade refers to a credit quality rating of BB or below.

3 – US Treasuries (UST) are represented by the Barclays US Treasury Index. Investment-grade corporate bond sectors (Aaa, Aa, A and Baa) s are represented by the respective components of the Barclays US Corporate Bond Index. Yields shown are yield to worst, which is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government index. The Barclays US Corporate Index is the corporate component of the Barclays U.S. Credit index. The Barclays U.S. Credit Index is the credit component of the Barclays Capital U.S. Aggregate Bond Index. The Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities.

4 – Spread refers to the difference in yield between two different types of fixed income securities with similar maturities.

5 – Municipal bonds are represented by the Barclays Municipal Bond Index. Muni High Yield (HY) is represented by the Barclays Municipal High Yield Bond Index. US Treasuries (UST) represented by the Barclays US Treasury Index. Spreads are calculated by subtracting the UST index yield to worst from the respective Muni index yield to worst. Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government index. The Barclays Municipal Bond Index is a rules-based, market value-weighted index engineered for the long-term tax-exempt bond market.

6 – The S&P 500 Index is a capitalization-weighted, composite index of 500 stocks designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Dividend Aristocrats is Standard & Poor's Index comprising the S&P 500 Index components that have increased dividends for at least 25 consecutive years. Constituents are equally weighted and re-weighted on a quarterly basis.

7 – U.S. and global small cap data derived from Royce & Associates' universe of US small caps (4,145 companies) and universe of global small caps (14,379 companies) as of 3/31/2012.

8 – MLP distributions may contain a return of capital. The Barclays U.S. Aggregate Bond Index yield is the yield to worst, which is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The S&P 500 Index is a capitalization-weighted, composite index of 500 stocks designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The MSCI US REIT Index is a market capitalization weighted index that is comprised of equity Real Estate Investment Trusts ("REITs") that are included in the MSCI U.S. Investable Market 2500 Index, with the exception of specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The index represents approximately 85% of the U.S. REIT universe. The Alerian MLP Index is a cap weighted, float-adjusted index created to provide a complete benchmark for investors to track the energy MLP sector.

Investment risks
All investments involve risk, including loss of principal. Investments in small-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.

Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.

Foreign securities are subject to the additional risks of fluctuations in foreign exchange rates, changes in political and economic conditions, foreign taxation, and differences in auditing and financial standards. These risks are magnified in the case of investment in emerging markets.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

A credit rating is a measure of an issuer's ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor's, Moody's Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

Real Estate Investment Trusts (REITs) invest in real estate or loans secured by real estate and issue shares in such investments, which can be illiquid.

Mortgage-backed securities involve additional risk over more traditional fixed-income investments, including: interest rate risk, implied call and extension risks; and the possibility of premature return of principal due to mortgage prepayment, which can reduce expected yield and lead to price volatility.

Master limited partnership (MLP) is a limited partnership that is publicly traded on a securities exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities in certain businesses; mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction, transportation and some real estate enterprises (e.g. real estate investment trust). In practice, MLPs pay their investors through quarterly required distributions. Failure to pay the quarterly required distributions may constitute an event of default.

Diversification does not assure a profit or protect against market loss.

This document is for information only and does not constitute an invitation to the public to invest. You should be aware that the investment opportunities described should normally be regarded as longer term investments and they may not be suitable for everyone.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Past performance is no guide to future returns and may not be repeated. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Please note that an investor cannot invest directly in an index. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed.

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