The S&P 500 was down -21.9% for the fourth quarter. It was an historic period in financial markets in just about every way, including market volatility, the collapse of credit markets, government intervention, forced selling and negative returns. We will review this briefly, and then focus on how the current situation affects investors seeking income.

The crisis which had been building for over a year, reached a new height when investment bank Lehman Brothers failed in September. Lehman’s debt and other securities were held by all sorts of investors, including banks, money market funds, hedge funds and foreign institutions. The failure set off a modern day bank run, with one of the oldest money market funds “breaking the buck” and rumors that supposedly sound financial institutions such as Morgan Stanley and Goldman Sachs were in trouble. When AIG failed several days later, the government had little choice but to step in and guarantee its obligations. AIG, a venerable insurance company, had gone to hell in just the past couple of years by putting on huge amounts of leverage and then writing hundreds of billions of dollars of insurance on the debt of companies like Lehman.

With markets virtually frozen at the end of September, the U. S. government announced the Troubled Asset Relief Plan, or TARP. The original idea of the plan was to help to recapitalize the financial system by purchasing the so-called toxic assets held by banks, brokers and other troubled financial institutions. The purchases were to be implemented by a “reverse auction.” The plan was funded with $700 billion. On Sunday evening September 30, the Treasury held a conference call for the financial community to describe the plan. Towards the end of the call, someone asked how long the plan would take to implement. The answer was that the plan would be implemented over the next several weeks. The financial community was clearly looking for something much sooner, and over the next two weeks the markets crashed, with price declines of 20-30%. At this point the plan was overhauled and used mostly for direct investment in financial institutions.

Unlike financial crises of the last 30 years, this one has had a profound impact on economic activity. Earnings results for the fourth quarter were very weak, especially for economically sensitive companies like autos, steel, etc. Furthermore, the performance of economies outside the U. S. has been even worse, putting an end to idea that these countries could “de-link” from the U. S. The current recession/ depression will be the biggest one in several generations.

Strategies for Income Investors

In seeking income, investors may be well advised to select companies with defensive business models which offer solid yields. The current depression in global economic activity threatens the dividend paying power of many companies. In fact, January, 2009 was the worst month for dividend cuts since at least 1956, which was when Standard and Poor’s started keeping records. Investors may also want to focus on companies with minimal exposure to commodities, and which employ modest, if any, leverage.

Over time, equities have provided good hedges against inflation, much more so than bonds. This should still be an important consideration for investors. While inflation has been moderate to negative in recent months, it is very possible this will prove temporary. One need only look at the record debt which is being used to finance government bail out and stimulus programs to see the potential for this to occur. The soaring price of gold, silver and other “store of value” commodities shows investors concerns about this.

Despite solid fundamentals, many income bearing instruments performed poorly in 2008. We believe this is due to the manic behavior of investors during times like these. To illustrate, consider the premium which investors required to hold yield generated by equity securities in pipeline companies compared to government bonds. In July of 2007 at the market peak, markets required almost no premium for the extra risk. Six months ago, the risk premium was around 3 percent, which was around the historic norm. Recently, the premium rose to 7 percent, higher than any recorded level. Have these securities become riskier? Possibly, but in our view not by nearly as much as the market would have us believe.

With credit spreads and risk premiums at record levels, we believe it is a prudent time for investors to consider defensive, dividend paying shares. While it would be foolish to try to call the bottom, we think income investors currently have the potential to be “paid to wait” until the inevitable recovery in the economy and financial markets arrives.

William R. Andersen, CFA is the Portfolio Manager of the Wanger Income and Growth Fund