If Wall Street is a struggle between fear and greed, both sides seemed plenty crowded this past week.
The fearful, eyeing political turmoil and deep fiscal woes in Greece, snapped up 10-year Treasury notes with yields as low as 1.70%, near their all-time low. Never mind that the latest reading on inflation was 2.3% for the year through April, suggesting those Treasury payments will fall behind the cost of living, sapping wealth rather than adding to it.
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The greedy crammed into Facebook (FB) in its stock-market debut. The price, even without a big first-day jump, will require some growing into. At Friday's close, shares fetched more than 100 times the company's profit last year, versus less than 14 times 2011 operating profits for the Standard & Poor's 500-stock index.
Between extremes like these, there remain some sweet spots in the markets. Here is where to find them.
Stocks. Big dividend payers like utilities and telecoms have gotten expensive, says John DeClue, chief investment officer at U.S. Bank. Better to favor companies with strong "free cash flow" -- surplus funds that can be spent in coming years on dividend increases, stock buybacks or growth.
Look for such companies in two industries in particular: technology, for growth-minded investors, and health care, for cautious ones. A screen of these sectors for high "free cash yield," which measures free cash flow over the past year as a percentage of market value, turned up Microsoft (MSFT) at 8.6%, Cisco Systems (CSCO) at 9.7%, Amgen (AMGN) at 7.1% and Medtronic (MDT) at 6.7%.
Among S&P 500 companies that generated free cash over the past year, the median did so at a yield of 5.1%, suggesting these four are less expensive than the market relative to their free cash.
Watch out for companies that pay generous dividends but also raise cash by repeatedly issuing new shares, says Jonathan Golub, chief U.S. equity strategist at UBS (UBS) . Issuing shares dilutes the value of existing ones, while buying them back can make remaining shares more valuable. Investors should avoid companies that consistently do more of the former than the latter.
The utilities sector, for example, has a meaty 4.1% dividend yield, almost double that of the S&P 500. But utilities have lately issued more shares than they have repurchased, so the sector's total payout yield (dividend payments plus buybacks, minus issuance) is 3.5%, less generous than the 5.4% total payout yield for the S&P 500, Mr. Golub says.
The consumer-discretionary sector has a dividend yield of just 1.6% but is a voracious buyer of its shares, resulting in a total payout yield of 7%.
Mr. Golub's team supplied a list of stocks with high total payout yields and "buy" recommendations from UBS analysts. It includes BlackRock (BLK), with a total payout yield of 11.8%; Time Warner Cable (TWC) at 10.9%; Travelers (TRV) Cos. at 10.5%; and Coca-Cola Enterprises (CCE) at 10.2%.
Kate Moore, global equity strategist at Bank of America Merrill Lynch, recommends another approach: looking for companies whose dividend yields exceed their bond yields. They likely are good values, but at the same time, their low bond yields suggest they are financially strong. Examples include Johnson & Johnson (JNJ), with 2018 bonds that yield 1.5% to maturity and shares that yield 3.8%, and McDonald's (MCD), whose 2020 bonds yield 2.4% and whose stock yields 3.1%.
Bonds. Falling Treasury yields have dragged down yields on other high-quality bonds. Among these are municipal bonds, which are issued by states, local governments and their agencies, and whose income is often tax-free.
"You must have us mistaken for another market," wrote Matt Fabian, managing director of research firm Municipal Market Advisors, in response to a request for good muni-bond deals.
Individual bond buyers can look for small blocks of high-yield bonds, but high commissions on such trades sometimes can offset the extra yield, Mr. Fabian says. Mr. DeClue agrees that high-yield munis are relatively inexpensive for investors who don't mind the risk, and recommends investing in them through mutual funds for diversification and lower fees.
"There's a perception that high-yield munis are like 'junk' bonds, but in reality municipal defaults are much rarer than corporate ones," he says.
The T. Rowe Price Tax-Free High Yield fund invests the bulk of its money in A and triple-B munis, as well as unrated munis -- ones whose credit-worthiness buyers must judge on their own. It has no upfront sales charge and ranks among the top 20% of peers for 10-year performance, according to Morningstar (MORN) . The fund yields 4.4%.
As for corporate bonds, yields are low for top-quality companies and even at the higher-quality end of the junk-bond market, to which investors have recently flocked, says Robert Levine, retired chief executive of Nomura Corporate Research and Asset Management and author of "How to Make Money With Junk Bonds".
The best junk values, Mr. Levine says, fall in a part of the market where most investors don't belong: triple-C-rated issues. A J.P. Morgan index of such issues yields about 12%, but triple-C-rated bonds are only a couple of notches above bonds that are in default.
There are far safer ways for bond investors to get better returns than Treasurys offer. Jurrien Timmer, who manages the Fidelity Global Strategies fund, recommends two. Emerging-market bonds, from countries like Turkey, Brazil and the Philippines, have sold off in recent days, but in general are benefiting from credit upgrades as these economies improve. One exchange-traded fund composed of such bonds, iShares JP Morgan USD Emerging Markets Bond (EMB), yields 4.7%.
Mr. Timmer also likes floating-rate bank debt, or business loans that have been sold by banks and trade as securities. These loans, like corporate bonds, come with the risk that companies will fall into financial difficulty and won't be able to pay, but they often are secured by collateral that can be sold off in such an event. Unlike bonds, the income they pay rises if interest rates broadly rise. Fidelity Floating Rate High Income, a fund composed of such loans, yields 3.3%.
—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com
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