Safeguarding your 'safe' investments

Dividend stocks and even bonds have been pretty rocky lately. Here's how to avoid getting burned.

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By Walter Updegrave, Money Magazine senior editor


(Money Magazine) -- The stock market can be a wild and woolly place. But at least you know you can count on dividend stocks, bonds and other income-paying investments to be a Rock of Gibraltar, right?

Not so fast. Income investments may have a reputation as the best way to offset the risks in other parts of your retirement portfolio. But subprime mortgage woes, a credit crunch and the threat of recession are making investing for income more challenging than you ever wanted.

The iShares Dow Jones Select Dividend exchange-traded fund, for example, lost almost 13% over the 12 months to late March compared with a decline of only 4% for Standard & Poor's 500.

There have also been some notable setbacks in bond funds, such as Regions Morgan Keegan Select Intermediate Bond, down a staggering 69% over the past year at least in part because of subprime mortgage holdings.

So how can you make sure that the safe part of your portfolio actually stays that way? Here are three tips.

Don't confuse dividends with interest payments. There's no question that dividend-paying stocks can play a valuable role in a retirement portfolio. Even though they're usually tamer than other stocks, however, they're more volatile than bonds and bond funds. So to the extent that you invest in dividend stocks and funds, you must consider them part of your stock allocation. Just be sure to round out the rest of your stockholdings with growth, small stocks and even some foreign shares.

Keep quality up, maturities down. The big concern these days is that a bond fund might own mortgage-related securities whose value could plummet if the housing and credit markets continue to deteriorate.

There is a way you can significantly lower your odds of getting blindsided, though: Invest in bond funds that concentrate primarily in high-quality issues, such as Treasury securities and high-grade corporate bonds (and high-quality munis for your taxable accounts).

When you're investing in bonds, you also need to protect yourself against the threat of losses caused by rising interest rates. Inflation has already been climbing - 4.1% last year vs. 2.5% in 2006 - and the Federal Reserve's efforts to stimulate the economy could shift inflation into even higher gear, pushing interest rates up and bond prices down.

The best way to protect yourself: Stick to bond funds with intermediate maturities of, say, five to eight years. As the chart shows, intermediate-term bonds typically pay most of the return of longer-term issues with far less volatility. You can create your own portfolio of high-quality intermediate-term funds by culling selections from the Money 70, our recommended list of mutual funds.

Remember that free lunches can be expensive. You also need to be careful about reaching for higher yields in your cash investments. There will always be investments that seem to offer fatter yields than plain old money-market funds without much extra risk. Two recent examples show how dangerous they can be.

Bank-loan funds, which invest in adjustable-rate corporate loans, have lost nearly 8% of their value over the year to late March. In the case of auction-rate preferred securities - typically income investments issued by closed-end funds - many owners have been unable to get out of their supposedly "short term" investments because the auction market has dried up (for more, see Answer Guy).

Lesson: When it comes to your cash investments - the ones you can't take chances with - limit yourself to secure options like short-term FDIC-insured CDs and money funds. True, money funds don't guarantee you against losses. But if you stick to funds issued by firms with solid reputations, your chances of experiencing any loss are minimal.

I'll admit that these tips won't lead you to the most exciting portfolio around. But in today's market, boring is beautiful.

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