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The Newest Yield Trap: Student Loans

Some income investors are getting desperate.

With the Fed reiterating its intention to keep interest rates near zero for another couple of years, the traditional yield avenues are essentially closed off. Certificates of deposit and money-market accounts are basically worthless. U.S. bond yields remain near historic lows, with the 10-year Treasury notes entering their 12th straight month of below a 2% yield.

Many investors starved for immediate returns are seeking radical alternatives. One place the yield hunters are satisfying their hunger is in student loans.

According to The Wall Street Journal, SLM Corp. (NASDAQ: SLM) – the largest student lender in the U.S. – sold $1.1 billion of securities backed by private student loans last week. SLM shares are up 16% in the last month. The stock has risen 25% since September, when the Fed announced its latest bond-buying program – known at the time as QE3.

The Fed’s announcement prompted income investors with an appetite for risk to seek out high-risk, high-yield vehicles. The student loan industry was ripe for the pickings.

Interest rates on private loans have been rising as the price of those loans has fallen. Student-loan prices are down in part because borrowers are having a tougher time paying off those loans.

At the end of the fourth quarter, 31% of student loans, both private and federal, were more than 90 days past due. That’s worse than the 24% delinquency rate at the end of the 2008 fourth quarter, in the middle of the recession.

Private loans tend to have higher interest rates than federal ones – hence the sudden flock to a stock such as SLM. The low-priced, high-interest rate loans are selling like hotcakes. Through February, $5.6 billion in student loans had been sold this year – more than triple the total through the first two months of 2012.

SLM is using the sudden inflow of cash to lure more investors. The company upped its dividend payment by 20% last week – just its third dividend increase in the last six years.

Sounds enticing, huh?

Don’t take the bait.

This looks like the student loan version of the subprime mortgage lending crisis that got us into this financial mess in the first place.

There are other places to find yield that are far less risky – not to mention less morally ambiguous – than an unpaid student loan. Plenty of dividend stocks offer yields that are attractive enough to entice income investors seeking steady returns without taking on nearly the same risk.

My High Yield Wealth portfolio, in fact, is chock full of lower-risk, high-yielding opportunities. You can subscribe by clicking here.

I realize that some investors thrive on risk and constantly search for the highest return regardless of the potential consequences. But that’s not who we cater to here at Wyatt Research.

High-yielding private student loans may be the new frontier for risk-tolerant income investors in this low-interest rate world. But there are other, more practical alternatives to bonds and the money market than taking on the huge risk of investing in student-loan debt.

Over the long haul, investing in the types of dividend stocks like we do at High Yield Wealth will earn you much steadier returns without the risk of losing your shirt.