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Income investing
Sniffing out high yields (the safe kind). As rates rise, these strategies will keep you on track.
April 21, 2005: 10:43 AM EDT
By George Mannes, MONEY Magazine

NEW YORK (MONEY Magazine) - If this is a time in your investing life when you're focusing less on the growth of your portfolio and more on the stream of cash you can draw from it, you're facing a real challenge.

Years of demand for Treasury and top-quality corporate bonds have ratcheted up prices and pushed down yields. Meanwhile, higher-yielding alternatives such as real estate investment trusts and low-rated junk bonds have grown increasingly expensive.

The upside possibilities seem slight, but what's worse is that the downside looks positively frightening. The rise in interest rates that started in the first quarter and the whiff of higher inflation in the air could whack the value of all long-term debt and hit real estate and companies with sub par credit especially hard.

In sum, this is no easy time to be searching for income.

"There's no area of the market that fund managers are pointing to right now and saying, 'Wow, look at that opportunity,'" says Scott Berry, an analyst with Morningstar.

So with historically low interest rates turning into rising rates, what are you to do?

Here are four strategies that, while they won't necessarily pay top dollar today, will generate decent short-term returns, lower your risk of a big loss and position your portfolio for the long haul.

Go short

Long-term bonds have higher yields than shorter-maturity debt, but there's a reason for that: risk. Right now the higher rates paid on bonds that mature in 10 years or more don't adequately reward holders for the risk of resurgent inflation.

So think about shifting money into a short-term bond fund. The MONEY 50's Vanguard Short-Term Bond Index fund (unchanged at $10.06, Research) yields 3.1 percent and has super-low fees.

Joe Birkofer, a certified financial planner at Legacy Asset Management in Houston, is recommending the Vanguard GNMA fund (unchanged at $10.41, Research), which has a 4.6 percent yield and an average effective maturity of 4.6 years.

A key advantage of the Ginnie Mae fund, says Birkofer, is that while it's behaving like a short-term bond fund today, managers are free to invest in longer-term maturities should conditions warrant it.

Wait

If you're about to ante up for new bonds or commit new money to a bond mutual fund, it may make sense to park that cash in a money-market fund and bet that long-term rates will be higher within a few months.

"You can get all these bonds on sale later in the year," says James Swanson, chief investment strategist of MFS Investments.

Buy stocks

While interest rates have been falling, the yield on stocks has been rising. Plus you get to keep more, thanks to the 2003 tax cut that dropped the maximum tariff on qualifying dividends to 15 percent.

But you shouldn't focus solely on dividend yields with stocks, since it's generally the earnings growth in equities that fuels your total return.

On a recent search for high-dividend stocks with earnings growth of at least 7.5 percent annually, MONEY's Michael Sivy found two promising candidates: packaged-food seller ConAgra Foods (Research), with a dividend yield of 4.1 percent, and consumer-products manufacturer Newell Rubbermaid (up $0.10 to $21.84, Research), yielding 4 percent. (Visit Money.com/sivy for more.)

For diversification among dividend-paying stocks, you can buy the iShares Dow Jones Select Dividend Index (up $0.32 to $58.54, Research), an exchange-traded fund that tracks nearly 100 stocks screened for factors such as stable or increasing dividends. The ETF recently yielded 3.1 percent. Though the iShares fund diversified in late 2004, it's still concentrated in financial services and energy.

A more diversified option would be a classic income fund such as Vanguard Wellington (down $0.28 to $29.30, Research), which has a 2.8 percent yield and is invested 65 percent in stocks.

Redefine income investing

Consider another approach to generating cash: selling securities. Rather than thinking of income as a stream of interest coupons and dividend checks, focus on the total return from your investments, and reap your cash not just from periodic payments but also from strategic sales of stock and bond holdings.

With this approach, says Tom Hardin, chief investment officer of Canterbury Financial Group in Indianapolis, you're holding bonds not so much to generate interest payments but to mitigate the ups and downs of your stock portfolio -- much as a properly diversified growth investor does.

How does this philosophy work in practice? You start out with a disciplined asset-allocation plan, says David Cowles, director of investments at San Francisco's Boone Financial Advisors.

Then, once any particular holding takes up a greater share of your portfolio than the percentage you've allotted for it -- for example, if foreign equities jump to 15 percent of your portfolio rather than the 10 percent you've allocated -- you sell a slice of the winner large enough to get you back to your target level. Some or all of the proceeds become your income.

The system, says Cowles, "allows you to invest for total return and not focus on what's throwing off cash, which may not have the best growth prospects in the long run."

This approach can also ease your tax burden, since the capital-gains tax bite on investments held more than a year is 15 percent, likely less than you'll pay on fully taxable interest income from bonds.  Top of page

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