(Money Magazine) -- You may want your portfolio to throw off a decent amount of income, either to fund current needs or because you (quite sensibly) don't want to rely on capital gains for all your investment returns.
But with the distinct possibility of rising interest rates, higher inflation, and lower returns, bonds hardly look like a sure thing. So what else can give you income plus inflation protection?
Actually, you have several options. Four popular ones: dividend-paying stocks, real estate investment trusts (REITs), preferred securities, and master limited partnerships (MLPs), which focus on the energy sector.
All of these income alternatives can be more volatile than bonds, however, so you don't want to load up on them. For example, Mike Scarborough, a money manager in Annapolis, suggests that you shift no more than 20% of your current bond allocation to dividend-paying stocks and preferreds. If you want to put in more money than that, take it from your stock holdings.
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Pros: Stocks of solid dividend-paying companies yield up to 6% or so, vs. 1.8% for the S&P 500. Because they're equities, they give you the potential for long-term appreciation, plus an inflation hedge. Tax treatment is favorable: You pay a top 15% rate on qualified dividends in 2010, vs. 35% for bond income.
Cons: When stocks go down, they tend to fall much further than bonds. (Remember that 57% drop in 2007-09? As if you could forget.) And the level of income is less certain: Though a bond issuer cannot cut interest once the bond is sold, firms can slice dividends anytime.
Look for companies that have a history of increasing dividends. A rising payout not only keeps you ahead of inflation but is often a sign of a well-run company. "Management is saying, 'We're confident about our earnings and positive about our future,' " says Rick Helm, head of Cohen & Steers' large-cap value investment team. According to Ned Davis Research, from 1972 to March 2010 the dividend growers in the S&P 500 returned an average annual 9.4%, compared with 7.3% for stocks with dividends that didn't consistently rise.
Don't overpay. "A dividend isn't worth it if you pay too much," says Greg Thomas, CEO of ThomasPartners, a Wellesley, Mass., investment firm. Keep an eye out for stocks trading below their historical price/earnings ratios (search for the stock ticker at morningstar.com, then click on the "valuation" tab) and whose P/E ratio is less than that of the S&P 500 (currently 18). And be wary of financial stocks, which have been on a tear this year
Aim for overall yields of 3.5% to 4%. Utilities and telecoms generally yield 4% to 6%; consumer goods and energy, 2% to 4%. The tradeoff: The highest-paying sectors, utilities and telecoms, have low growth potential. So own a mix of these sectors to earn more than 3% while also shooting for long-term growth. Because high yields can indicate high risk, avoid stocks outside utilities and telecom that pay more than 4% now.
Diversify. If assembling a mix of individual issues isn't your thing, buy a fund such as SPDR S&P Dividend ETF (SDY), which tracks the highest-yielding stocks in the S&P 500 High-Yield Dividend Aristocrats index (firms that have increased dividends for at least 25 years in a row). For a tad more yield, add a utilities or a telecom fund.
Pros: REITs -- publicly traded pools of commercial properties or mortgages -- have historically been a good inflation hedge. And REITs don't usually move in sync with stocks (the past few years have been an exception).
Cons: A recent rally has made REITs expensive and lowered yields. Payouts are taxed as regular income.
Pick the right kind. REITs come in two basic flavors: equity REITs, which own commercial property, and mortgage REITs, which make or own commercial loans. Stick with the former. While mortgage REITs offer much higher yields, they're quite risky, thanks to continuing woes in the commercial mortgage market.
Be realistic about yield. Equity REIT yields have fallen from 9% in March 2009 to less than 4%. Many REITs on the most solid financial footing yield less than 3% today. Still, that's more than five-year Treasuries are paying now.
Go with mutual funds or ETFs. They let you spread your bets among different types of properties (malls, health care facilities, and so on). For geographical diversification, devote some money to a global REIT fund.
"We believe there will be higher economic growth outside the U.S.," says Jeff Layman, chief investment officer of BKD Wealth Advisors, "and when you have economic growth you tend to see property values rise as well."
Dollar-cost-average your way in. Many advisers recommend keeping about 5% of your portfolio in REITs. Not there? Make periodic investments over the next year or so. That way you won't buy a big chunk when REITs are pricey.
Pros: Neither a common stock nor a bond but a special breed of quasi-debt issued by corporations, a preferred share has unusual benefits. It typically provides the stability of an income payment that doesn't change, just as a bond does. The typical preferred yields 6% or more now, about two percentage points higher than investment-grade corporate debt. Some are taxed at 15%.
Cons: A fixed-income payment isn't great in a rising-rate environment. Holders are subordinate to bondholders, meaning they're a rung lower in the payback ladder -- a bad place to be if the company hits the skids. And more than 80% of preferreds are issued by financial services firms. So buying them is essentially a bet on that sector, albeit a safer one than investing in common stock.
Stick with ETFs, such as iShares S&P U.S. Preferred Stock ETF (PFF). Doing so is easier than investing in individual issues, and you'll get instant diversification within the financial sector.
Know your limits. Because preferreds are concentrated in just one industry, "think of them as the vitamin for your portfolio, not the full meal," says Susan Fulton, president of FBB Capital Partners in Washington, D.C. Invest more than 5% to 10% of your money, and you may be asking for trouble.
Pros: MLPs are largely a play on one industry: energy. Most invest in companies that own pipelines, store gas, and ship oil, for example. The biggest advantage of MLPs -- which used to have a rep as tax dodges for the wealthy -- is the yield: generally 6% and up. The payout can increase, potentially protecting against inflation.
Cons: They're volatile: A leading index of MLPs fell 56% from its 2007 high through its 2008 low. Because they tend to borrow money for acquisitions, rising rates can hurt profits. Payouts are not guaranteed, and these days they are taxed as ordinary income.
Don't think of MLPs as all-purpose income investments. They're too risky to function well as bond alternatives. Still want a taste? Put a small percentage of your portfolio in an exchange-traded note (ETN) -- a debt security that trades like an ETF -- such as J.P. Morgan Alerian MLP Index ETN (AMJ). If the past few years have taught us anything, it's that getting greedy can lead to a massive case of indigestion.
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