High-yield strategies for a low-yield era

NEW YORK (Money Magazine) -- Recently I've been getting a lot of e-mails from readers wondering how they can find investments that offer high income at a time when most stocks and bonds are paying disappointing yields.

Of course, everyone would love to find a way to get double-digit income without any risk. But that's not possible in today's market - if in fact it ever was.

Even when interest rates were above 12 percent in the early 1980s, high inflation ate up most of those returns. Today's Treasury bonds are offering only around 5 percent, while the stocks in the S&P 500 pay dividends averaging 1.8 percent, not quite half their historical level.

But you can find alternatives that are considerably more rewarding and that will help you reach your financial goals, whether you're saving for a car or a house, stashing money away for retirement or drawing down your savings once you're no longer toiling for your daily bread.

Just as important as the amount you earn, though, is the security that income investments provide. Including them in your mix will smooth out the bounces in your portfolio while making the progress toward your goals more consistent.

Over long stretches, dividends and interest combined can contribute as much as half the return on a balanced mix of stocks and bonds. In fact, they may be the only things pushing up the value of your holdings when stock prices go into a slump - as they will again someday.

So you need to have an income-investing plan no matter how the stock market is performing or what you plan to do with your savings. In this story you'll learn how to choose a strategy that works best for your time frame and goals. And you'll find four portfolios that can help you get the right mix of yield and safety.

With inflation running at less than a 3 percent annual rate, short-term yields of 5 percent or more are very attractive right now, and they're not particularly hard to find. You just need to know where to look.

If you have a time frame of a year or so - because you're saving for a car, say - you've got two basic strategies you can pursue.

First, you can lock in a yield on a certificate of deposit that matures shortly before you'll need your money. Giants such as Bank of America and Chase are paying less than 4 percent on one-year CDs. But if you hunt around for special promotions and widen your search to smaller and Internet-only banks, you can grab a rate as high as 5.4 percent on even a small investment.

Deposits of as much as $100,000 are typically federally insured. The alternative, if you need the freedom to get your money at any time, is a bank money-market account. You'll find the best yields online.

Or if you prefer, you can rely on a money-market mutual fund. Although not federally insured, those at leading fund companies are safe, and today they frequently pay better than 5 percent.

Normally with this time frame you can safely enhance your return by investing part of your money in bonds that mature in five years or longer.

But the current pattern of interest rates is unusual. Short-term yields are just as high as those on many longer-term choices. The reason: Bond investors anticipate an economic slowdown that would allow interest rates to fall.

As a result, yields on longer-term bonds aren't as high as they would otherwise be. So if keeping safe matters most to you, stick with the short-term investments discussed in the previous section.

But you can still kick your returns up a notch if you're willing to take a little bit of risk.

Put half of your savings into longer-term mutual funds, splitting that sum between an investment-grade corporate or total market bond index fund and a high-yield or junk bond fund.

In reality many junk funds are only a little bit riskier than investment-grade, but they still pay above-average yields. (The Money 70, our list of recommended mutual funds, has choices in all these categories.)

The reasoning goes like this: To get the most income, you want a high-yield fund paying out 7 percent or more. But you don't want to put all your money there because even a well-run junk fund can lose value temporarily in a bad economy. You're not likely to lose principal over five years or longer, but if there's a recession at the time you have to withdraw your money - to pay college costs, for example, or to buy a home - you could come up short.

Including an investment- grade or total-market bond fund can hedge against that because those funds shouldn't suffer in a slump. They might even benefit if a recession causes short-term rates to fall (as is often the case) and savers rush to better-paying long-term investments.

When you're looking out 10 or 20 years toward retirement, you might wonder why you even need income investments. You know you want the capital growth that stocks provide. And it will be years before you have to draw income from your portfolio. But you need an income strategy for safety and to sustain your returns.

On the safety front, you want to own bonds, of course, because their prices don't move in lockstep with those of stocks. That's Diversification 101.

But you also want bonds because their interest payments are predictable and stock returns aren't. Even over periods as long as 15 years, stocks fail to beat today's best fixed-income yields about 20 percent of the time. Putting at least 20 percent of your money into the same kind of bond funds you'd own with a five- to 10-year horizon lays a good foundation.

Interest payments alone, though, aren't enough. Because they don't rise over time, they'll leave you exposed to inflation. So invest as much as half of your money in stocks that pay dividend yields of 2.5 percent or more and are likely to raise their dividends faster than inflation. The rest can go into growth stocks.

The easiest way to invest in yield stocks is through the equity-income fund offered by a no-load mutual fund company.

Vanguard's Equity Income fund (VEIPX) is one of the highest yielding. It has a 2.5 percent payout and has earned a 15.6 percent compound annual return over the past three years.

If you prefer to invest through your brokerage account, the SPDR S&P Dividend ETF (SDY) yields 2.8 percent and returned 17.7 percent last year.

If you have more than $25,000 in your equity portfolio and you prefer to invest in individual stocks, there are four companies in the Sivy 70 that look timely and offer yields above 2.5 percent.

After losing ground to PepsiCo for nine years, Coca-Cola (Charts, Fortune 500) looks ready for a turnaround based on international expansion and new products that use less sweetener.

General Electric (Charts, Fortune 500) remains a fine conglomerate that's now surprisingly cheap and pays a 3 percent dividend.

Eli Lilly (Charts, Fortune 500) has lagged other major drug stocks and appears undervalued.

Finally, Wells Fargo (Charts, Fortune 500) has among the best growth prospects of all the major banks.

At the point when you retire, you'll want as much predictable income as possible. But don't let that make you overreach for current yield by relying totally on bonds and CDs. You could live 30 years after you stop working full time, and over that period even low 2.5 percent inflation would cut the value of a dollar in half.

So besides bonds, you'll need highyielding stocks with payouts that keep growing. If you have a big retirement account - more than half a million dollars - you can squeeze out a higher return with individual bonds.

When you stand to earn 5 percent or so a year, paying half a point in annual expenses on a fund eats up a tenth of your return. Individual Treasuries are easy to buy through your broker or through Treasury direct (savingsbonds.gov).

Focus on issues that mature in 10 years or longer. Also take a look at municipals if you're still in a top tax bracket. But to buy individual taxexempt issues, you'll need advice from a muni bond specialist.

Don't want to manage your own bond portfolio in retirement? Then just stick with funds. For high-quality issues you can select from the bond funds in the earlier sections.

The most cost-effective approach is through a single fund like the Vanguard Total Bond Market Index (VBMFX), which currently pays 4.9 percent.

To enhance your return, include highyield bond funds. One good choice is American Funds American High-Income (AHITX), which yields 7.2 percent.

But you can also earn 7 percent on Vanguard's High-Yield Corporate (VWEHX) bond fund. It has one of the highest-quality "junk" portfolios, and you won't pay a broker's commission as you would with American Funds.

For the stock portion of your portfolio, include blue-chip stock funds or individual stocks discussed in the last section. Also look at top electric utilities. They offer high payouts while still increasing earnings fast enough to allow dividend growth to outpace inflation.

Utilities fare best in fast-growing regions. Two attractive stocks are Georgia's Southern Co., yielding 4.4 percent, and North Carolina's Duke Energy, yielding 4.2 percent.