(MONEY Magazine) – Recent signs that the economy is slowing have sparked rallies in both stocks and bonds as investors anticipate that the Federal Reserve will let interest rates decline. This trend toward lower rates has already begun. Yields on long-term Treasury bonds have dropped from 9.3% in April to a current 8.5%. Now many economists believe that long-term rates could ease to 8% by year-end and might sink as low as 7% within the next three years. With rates heading downward, this is an ideal time to lock in yields that are still relatively high. In addition, even a small further decline in rates could bring capital gains of 5% to 10% on bonds and on interest-rate-sensitive stocks such as electric utilities. Many individuals consider income investing to be a strategy for fuddy- duddies. They are wrong. When rates are moving lower, as they are now, income investments can provide total returns that come close to those of growth investments -- with much less risk. Over the past five years, for example, long-term Treasuries have returned an average of 18.1% annually, compared with 20.2% for Standard & Poor's 500-stock index. Since bonds are less volatile than stocks, the Treasuries were clearly an attractive alternative after weighing the risk. To get the highest safe yield, you should consider putting together your own income portfolio -- even if you have only $10,000 to invest conservatively. If you have more money -- say $50,000 -- you can include a few riskier picks and still be well diversified. Conservative investors worry most about default risk -- the danger that a bond or stock will fail to make its payments on time. Defaults are actually extremely rare. And you can keep this danger to a minimum if you follow one simple rule: Stay away from junk bonds. Their higher yields aren't worth it. A recent study by researchers at the Harvard Business School concluded that over a 10-year period, one-third of all junk bonds defaulted. A far more serious threat to your financial health -- and the one you should take the greatest precautions against -- is inflation. After the dizzy price increases of the late 1970s, people now regard a 5% annual inflation rate as tolerable. But even 5% inflation takes a horrendous toll on your purchasing power. After only five years, it would erode the value of your money by 22%. Bonds do nothing to protect you against inflation; the amount of their payments is fixed. But there are investments, such as utilities and income vehicles with the characteristics of stocks, that raise their dividends enough over time to match or even exceed inflation. A number of attractive income investments are outlined further on, and you can mix and match them according to your tolerance for risk and the amount of money you have available for new investments. With less than $10,000, you can assemble a double-digit income portfolio by putting one-third of your money in the Blackstone Target Term Trust, one-third in Quest for Value Income shares, and by using the rest to buy a couple of utilities and a real estate investment trust. If you have more capital, just pretend you're in a tapas bar -- try a little of each of the following high-yield investments. You should select some that pay 8% or 9% but offer maximum growth, and then juice up your portfolio's yield by choosing other issues that pay 11% or more. The most important thing is to diversify broadly and to include riskier investments only if you have a taste for spicy dishes. Here's what's on the menu: Bonds. Treasury securities are worth including because they eliminate default risk. Still, at yields of 8.5%, long-term Treasuries aren't all that compelling. Include them only if you have a portfolio of $50,000 or more so that you can balance them with substantially more aggressive growth investments. Corporate bonds are generally a waste of time for small investors. Not only do you have to worry about defaults; in addition, many corporates can be called -- that is, redeemed early. If that happens, you will find that you haven't locked in the high yields you thought you had. Unless you can evaluate the finances of the issuer and a bond's call provisions, skip 'em. Mortgage-backed securities, such as Government National Mortgage Association issues known as Ginnie Maes, are government guaranteed and pay as much as 1.5 percentage points more than Treasuries. The drawback of Ginnie Maes is that they are complicated; they pay a mixture of principal and interest that can change unpredictably if homeowners start refinancing their mortgages faster. In addition, most Ginnie Maes require initial investments of $15,000 to $25,000. Perhaps the best way to cash in on the Ginnie Mae yield advantage is through a little-known closed-end fund called the Blackstone Target Term Trust (recently traded on the New York Stock Exchange at $9.50). This fund holds only AAA-rated investments, including Ginnie Maes and zero-coupon Treasury bonds. In December 2000, the trust is designed to liquidate at a price of $10 a share. ''The fund keeps enough zeros in its portfolio to enable it to pay $10 at maturity,'' explains Steven M. Cress, a closed-end fund analyst at Prudential-Bache, one of the trust's underwriters. Best of all, Blackstone pays a 10.4% yield. Municipals. Even with today's lower federal tax rates, some municipals remain very attractive for single people earning more than $18,551 and couples with joint incomes above $30,951. Bonds issued in the state in which the holder resides are usually exempt from state and local, as well as federal, taxes. These combined taxes can total as much as 40% in high-tax states, giving a 7% municipal a yield equivalent to 11.7% on a taxable bond (see the table on page 8). For a fuller discussion of tax-exempts, see Investing Basics on page 121.

International bond funds. High-quality bonds in some foreign countries offer double-digit yields; the simplest way to invest in such issues is through an international bond fund. The only problem with such funds is that their share price can change considerably with fluctuations in the value of the dollar -- a significant worry at present because the dollar has been strengthening, which devalues bonds in foreign currencies. ''Foreign bond funds should be part of a portfolio for reasons of diversification, not because of their high yields alone,'' says John Dessauer, publisher of Dessauer's Journal (P.O. Box 1718, Orleans, Mass. 02653; semimonthly, $195 a year), a newsletter covering foreign investing. The one closed-end fund that Dessauer recommends at present is First Australia Prime Income Fund (American Stock Exchange, $8.50), which yields 12.6%. More important, says Dessauer, the Australian dollar is at a fairly reasonable level compared with the U.S. dollar. ''First Australia has less currency risk than most other foreign bond funds,'' he says. Electric utilities. ''Utilities have moved sharply higher in the past month because of lower interest rates, but I think they have further to go,'' says Thomas Serzan, analyst at Gruntal. In general, utilities with yields of more than 8% are increasing their earnings slower than those with yields below 7%. But many high-yield utilities can still raise their dividends enough to offset inflation to a substantial degree. Among the specific issues that analysts recommend are Central Illinois Public Service ($22, yielding 8%), DPL ($26, 8.6%), Delmarva Power & Light ($18.75, 8%), Houston Industries ($29.25, 10.1%), Public Service of Colorado ($22, 9%), and Texas Utilities ($30.50, 9.5%). All are traded on the New York Stock Exchange. Real estate investment trusts. These trusts either own equity in properties or engage in mortgage lending. Mortgage REITs are similar to bonds in the sense that they offer little inflation protection. REITs with equity participation, though, can increase their payouts over time as rents on their properties rise. Bruce Garrison, an analyst at Lovett Mitchell Webb & Garrison, an investment research firm based in Houston, recommends three REITs that offer growth potential and that yield more than 9%. Copley Properties (ASE, $15.25, 11%) owns 15 office buildings and shopping centers, mostly in California and Maryland. Garrison believes the REIT's dividend may be cut 10% later this year, but that would still leave Copley with an appealing 10.2% yield, based on its current price. Sizeler Property Investors (NYSE, $15.25, 10.1%) owns 10 shopping centers, seven of which are in Louisiana. Garrison thinks Sizeler will be able to maintain its current dividend and that property values in Louisiana are rebounding. He also likes Dial REIT (traded over the counter at $18, 9.1%), which owns 17 shopping centers in the Midwest, many of which rent space to Wal-Mart stores. Garrison thinks Dial is likely to raise its dividend over the next year or two. In addition to bonds and stocks, there are some more complicated income investments worth considering, such as the two that are outlined below. Ask your broker to check and explain any aspects that seem puzzling. Americus Trusts. These trusts hold the shares of blue-chip stocks and have two securities outstanding that, in effect, separate a blue chip's dividend income from part of its capital-gains potential. When the trust dissolves at a specified date in the future, holders of the so-called Score security receive the stock's value in excess of a certain price; holders of the Prime security receive the stock's value up to that price, as well as all dividend income over the life of the trust. Alan Marcus, a broker at Shearson Lehman Hutton, specializes in Americus Trust Primes. (These issues are listed in the American Stock Exchange tables under the letter 'A.') He currently recommends two for income investors. The Ford Prime ($80.75) yields 7.4% vs. 6.1% for Ford common stock. Since Ford split two for one after the trust was set up, each Prime represents two shares, and receives all capital gains in 1992, up to a price of $52 for current Ford stock. The General Motors Prime ($73) yields 8.2% vs. 7.4% for the common. Since GM has also split two for one, holders will receive all capital gains on GM in 1992, up to a price of $53.50 for current GM shares. Analysts say that on a long-term basis, Ford and GM are among the cheapest blue chips. Dual-purpose funds. A few closed-end funds are set up in a way similar to Americus Trusts, with income shares that receive all the dividend income from the fund's portfolio and capital shares that receive all the capital gains above a certain price at a specified date. Analysts recommend the Gemini II Income shares (NYSE, $12.75) very highly, in large part because the fund is run by superstar manager John Neff, whose well-known Windsor Fund was recently closed to new investors. Gemini yields 11.1% and could increase its payout by as much as 10% a year. The catch is that the fund has already raised its payout so high that it is trading above its termination value. In 1997, holders of the income shares will receive only $9.30, a loss of 27% from the fund's present price. But that's not as much of a drawback as it sounds. ''The accumulation of Gemini's rapidly rising dividends will more than offset the eventual loss at maturity,'' says Steven Samuels, a partner at Drake Capital Securities in Santa Monica. A close second choice is Quest for Value Income shares (NYSE, $11.75, 10.1%). While Quest's payout is not likely to grow as fast as Gemini's, analysts say, the income shares will receive $11.60 in 1997, so there will be scarcely any loss at maturity. Notes Samuels: ''These income shares are like superbonds because their payouts keep rising. Not only do they provide high yields, but in both cases they have returned more to investors in the past than the capital-gains shares of the same funds.''

CHART: NOT AVAILABLE CREDIT: Source: Merrill Lynch CAPTION: At a Glance What muni yields are really worth Investors who buy munis issued in their own states usually escape state and local taxes, as well as federal taxes. The table shows muni yields for nine states and cities and their taxable equivalent yields -- in other words, what an investor would have to earn on a taxable bond to come out ahead after federal, state and local levies.