(MONEY Magazine) – The choices for income investors couldn't be lousier right now: Short-term yields are barely keeping pace with today's 3.1% inflation -- including those on certificates of deposit, money-market funds and three-month Treasury bills. And though long-term bonds offer more than 7.4%, those returns could be eroded to as little as 2% if interest rates rise half a percentage point this year, as many economists expect, driving bond prices down by 6% or so. There is an attractive income investment available, however -- select electric utility stocks. The 11 top-quality utilities listed in the table at right pay yields of 5.5% to 6.7%. And although they would suffer some short- term price drop if interest rates rose, utilities have far better potential than bonds for long-term gains. During the 1980s, for instance, the 50 financially strongest electric utilities provided a 21% average annual return, according to MCM Investment Research, a subsidiary of the Chicago investment management company Duff & Phelps. By contrast, Shearson Lehman's index of long-term bonds returned only 14% a year over that period. The reason for the utilities' 50% advantage: steady dividend increases. For example, take the case of a utility and a bond that both start off paying 6.2%. If the utility raises its dividend 2.5% a year, after five years its yield would be 7%, based on original cost. And most likely the stock's price ! would have risen in line with its yield -- that is, by about 13%. By contrast, the bond, which has a fixed payout, would still be yielding 6.2% and trading at roughly the same price. Of course, if interest rates go up temporarily, utility share prices would fall just as those of bonds would. But when interest rates come back down again, the utilities would most likely end up ahead of the bonds. ''The strongest utilities finish each interest-rate cycle a little higher,'' says Roger Conrad, editor of the newsletter Utility Forecaster (monthly; $87 a year; 800-832-2330). Recently, small investors searching for higher income have rediscovered utilities. As a result, the share prices of popular top-quality issues such as Duke Power & Energy have jumped by as much as 25% in the past 18 months. But there are other lesser-known choices that are more attractively priced and offering dividend yields of 5.5% or more. To find them, MONEY started by asking G.R. Pugh, an industry research firm in Cranford, N.J., to screen 94 major electric companies. The first test was to look for a yield of at least 5.5% but reject those above 7.5%. Yields higher than that could be a sign that a company's price is depressed because it faces a major problem.

The second factor we weighed was the utility's prospects for dividend growth. Says Jack Ryan, portfolio manager of Vanguard's Utilities Income Fund: ''It makes sense to give up a percentage point of annual yield to get three or four points more dividend growth a year.'' The higher the dividend growth, the faster a utility stock's price rises, and rapid appreciation can more than make up for the reduction in current yield. Ten of the companies listed here are likely to match or exceed the industry's 2.5% average dividend growth over the next five years, according to Value Line's projections. The exception: Southern Co., which gets a below- average dividend growth rating from Value Line but an above-average rating from Duff & Phelps. The payout ratios show how much of a company's earnings are used to pay its dividend. High payout ratios mean that any drop in earnings could force a dividend reduction. We eliminated any power companies where the payout ratio topped the 89% industry average. All 11 companies on the list are regulated by state agencies judged to be 3 (average) or better by Merrill Lynch, which assesses the fairness and consistency of such agencies in their dealings with the utilities they regulate. For example, high-scoring agencies are more likely to permit companies to raise electric rates promptly if their cost of generating power goes up. The companies that made our cut are low-cost producers. That's important because the cost of electricity will increasingly determine utilities' profits, analysts say, thanks to the Energy Policy Act passed by Congress last fall. The act will force utilities to buy power from independent producers in their regions, even though that may mean they have to idle some of their own higher-cost generating plants. The table shows the current cost of electricity to residential customers -- the best gauge of a company's overall production costs, compared with those of the industry. San Diego Gas & Electric and New England Electric System, though fairly high cost by national standards, have lower costs than other utilities in the area and are unlikely to be undercut by local competitors. In addition to meeting these standards, our 11 utilities have earned above- average Value Line safety ratings, which are a measure of financial strength. And we included only companies that have made every dividend payment over the past five years while increasing their payouts over the period. The experts we spoke with also offered these two tips for income investors: -- Turn off on power companies that involve themselves in other businesses. ''Get nervous if your utility buys a steel mill, a drugstore or an insurance company,'' says Merrill Lynch analyst Leonard Hyman. Electric companies have often earned nothing but big write-offs when they tried running subsidiaries unrelated to their basic business. For example, in 1989 Pinnacle West in Arizona had to suspend its dividend because of real estate losses at its banking subsidiary. -- If you buy several different utility stocks, insulate your portfolio with geographical diversity. Regional recessions and weather patterns can reduce power usage and hurt companies' revenues and profits. For instance, last year's exceptionally cool summer meant that earnings at several midwestern companies, which normally sell millions of kilowatt-hours to run air conditioners, were depressed by as much as 20%. By investing in companies in several different parts of the country, you can stay cool while collecting sizzling yields.

CHART: NOT AVAILABLE CREDIT: Sources: G.R. Pugh & Co., Merrill Lynch, Value Line Investment Survey CAPTION: Electric utilities that can light up your portfolio These 11 electric companies pay 5.5% to 6.7% and are the best choices based on eight tests for safety and long-term growth.