Boost your bond yields

Boost Your Bond Yields

There's no getting around it: You have to take on some credit risk to wrest 4% from fixed-income assets these days. Treasuries, with yields ranging from 0.8% to 2.5% on intermediate-term issues, just won't cut it.

Even a diversified bond fund like Vanguard Total Bond Market Index (VBMFX), which revs up yields by blending a 30% stake in Treasuries with higher-rate mortgage-backed securities, corporate bonds, and foreign issues, gets you only to 3.5%.

Fortunately, you don't have to dive deep into the junk pile to earn a decent payout. Putting just a quarter of your fixed-income assets into high-grade corporates, when paired with the strong foundation that a total bond index fund provides, can get you to 4%. Willing to put 10% to 20% into somewhat riskier issues? You can do even better.

1. Add some higher-quality junk. Bonds rated BB+ or lower have surged 65% over the past 18 months, as default fears subsided and yield-starved investors grew too desperate to stay away. As a result, yields have plunged from as high as 23% to 8.5% today. (As bond prices rise, yields fall.)

But that's still seven points higher than the average Treasury bond for the debt of companies in much better shape than they were a year ago the default rate on high-yield issues is now 5.5%, vs. 11% in 2009. Notes Marilyn Cohen, founder of Envision Capital Management: "You're not getting stuck with businesses that have one leg on a banana peel, on their way to the grave."

Still, with talk of a double-dip growing, be cautious, putting no more than 10% of your assets in junk. And stick with the two top credit tiers in the junk universe (issues rated B or better) through a high-yield or diversified bond fund that focuses on these securities (for picks, see page 98).

2. Sprinkle in some foreign flavoring. Like junk, bonds issued by emerging-market countries such as Brazil and Russia have been on a tear lately. But their average 5.4% yield still looks rich compared with Treasuries and high-grade U.S. corporates.

Though the bonds had a higher default rate than European debt last year 3.5% vs. 1.4% -- they fared better than U.S. debt (average default rate: 5.6%). Minimize volatility with a proven fund such as Fidelity New Markets Income (FNMIX), which has beaten 94% of its peers over the past five years. Recent yield: 6.4%.

3. Ease the tax bite. If you're investing in a taxable account, the stiff bite on interest earnings from bonds will erode your real return. Solution: federally tax-exempt munis, recently yielding an average 2.9%, which is equivalent to 4% if you're in the 28% bracket.

While many states face steep revenue shortfalls due to the shaky economy, the historical default rate on munis is low -- under 1%. And you can minimize the risks by investing in munis from many different states through a fund such as Vanguard Intermediate-Term Tax-Exempt (VWITX), which was recently yielding 3.6% (equal to 5% in the 28% bracket).