A Portfolio For A Good Night's Sleep Even in history's greatest bull market you need something safe in your portfolio. We name some great ways to invest for income. (And they're not just triple-A bonds.)
By Amy Kover

(FORTUNE Magazine) – A few months ago Ted Giuliano, head of Neuberger & Berman's bond department, went out for a dinner with his wife, Hilary Woods Giuliano, who runs stock funds at Dreyfus. Hilary gallantly picked up the check, but not before hitting her husband with a zinger right between the appetizer and the entree. "How does it feel," she teased, "to have spent your entire career in the wrong asset class?"

Not exactly a romantic line, but most investors would understand the question. As stocks have rallied by an amazing annual average of 29.5% over the past three years, the world seems to have forgotten all about income-oriented investing. Traditionally people have put their money largely in stocks as they build toward retirement, then moved more assets into fixed income once they retired. But now financial planners are telling clients to continue holding as much as 70% in equities even after they've stopped working.

Why? One of the greatest risks future retirees face today is that they will outlive their savings. After all, from 1977 to 1997, the average U.S. life expectancy increased by more than three years, to 77. And the longer you live, the more time inflation has to eat into your money's value. Since a bond's interest payments and face value are fixed, bonds have notoriously failed to hold up under inflationary pressure. Hence, stocks are the answer.

All that's true enough. There's just one catch: Even the most brilliant stock portfolio won't save you in a bear market. But an income investment can protect part or all of your money in nearly any noninflationary panic.

For one thing, almost all income-oriented vehicles regularly pay either dividends or interest--so, except in the most outre versions, you get some return no matter what. Even more important, income investments provide you with much needed diversification. The best way to reduce a stock-heavy portfolio's volatility is to add some investments that have negative correlation with the stock market--meaning that they have historically yinged whenever stocks yanged. You don't get that kind of protection if your whole portfolio moves in sync with the drumbeat of quarterly earnings projections. No wonder Giuliano didn't flinch when his wife made fun of bonds. Instead, he says, "stocks help you eat well, but bonds let you sleep well." Touche.

And not only bonds. While this stock-smitten market makes it seem as though there's little to choose from in the income arena, FORTUNE has come up with several great ideas.

--Dividend-paying stocks. If you don't want to veer too far from the stock market, go ahead and buy more stocks. Dividend-paying stocks, that is. While the S&P 500 pays a mere 1.2% dividend yield, stocks in utilities, financials, energy, and consumer staples sometimes produce as much as four times that. So you get the security of a steady dividend plus a little price-appreciation kick. Even more important, dividends can cut down on your portfolio's volatility. In the five-year period ended December 1998, the value of the 100 highest-dividend-paying stocks swung 44% less than that of the 100 lowest-yielding stocks, according to Pioneer Funds. "Though many of these companies might grow at slower rates, they do tend to be more conservative and stable," says John Carey, who manages Pioneer Equity Income.

Comfortable. Stable. Sounds like a definition of the electric utility stocks of years past. Fat-cat utility companies historically operated as huge regional monopolies that could easily crank out consistent revenues and pay investors around 4% in dividend yields each year. All that has changed now that deregulation has made the industry more competitive. Today many companies are cutting their dividend payments to make performance-enhancing capital investments instead. "Dividend safety is a much smaller universe these days," explains Morgan Stanley utility analyst Kit Konolige. He suggests looking for businesses that specialize in distribution, an area still heavily regulated. Two choices might be New Jersey-based GPU, which spins off a 4.9% dividend yield, or Con Edison, which pays 4.8%. And while the two certainly didn't match the S&P 500's doubling in value over the past three years, they didn't exactly sit still. Had you invested in Con Edison three years ago, your stock, not counting dividends, would have risen 58%; GPU, by 22%. If you're looking to add some safety and diversification to a portfolio laden with fat growth stocks, that's not a bad tradeoff.

Another intriguing, albeit a bit riskier, option is financial stocks, which have traditionally thrown off slightly above-average dividend yields. The main appeal here, though, is appreciation: Consolidation in areas like regional banking and insurance should continue to pump up the stock price. To stay on the safe side, James Ellman, who manages the soon-to-be-launched Merrill Lynch Global Financial Service fund, suggests looking for financial companies that depend on fee-based businesses rather than unpredictable capital market trading. He likes Bank of America, which has booked 8% annual earnings growth over the past three years, mostly from fee-based products, and yields around 2.3%. Want a bigger dividend? Try money manager Alliance Capital, which spins out 5.6% in "partnership units" (the equivalent of dividends for a master limited partnership).

--Real estate investment trusts. For the ultimate diversification, you could move away from stocks and bonds entirely and try a little real estate. The easiest way to do that would be through real estate investment trusts (REITs), the stocks of corporations that hold pools of properties such as apartment buildings, hotels, or malls. REITs hand out very generous dividend yields--an average of 7.39% as of the end of June--and their land holdings offer the promise of some capital appreciation. Best of all, REITs tend to move in the opposite direction of large-cap growth stocks. A study by Keith Pauley and Todd Canter of LaSalle Investment Management indicates that REITs have very high negative correlations with large-cap stocks in both technology and communications. That can smooth out periodic jolts in your portfolio. In fact, the LaSalle study shows that a portfolio with five-year annualized returns of 30% cut its standard deviation (the recognized statistical measure of volatility) by nearly 15% simply by adding REITs.

Just one warning: REITs should be used for income, not growth. Many people forgot this back in 1996 and 1997, when the trusts' value rallied by 56.3%. "We were the dot.coms of the year," jokes Skip Aylesworth, portfolio manager of FBR Realty Growth. But price chasers suffered the consequences in 1998, when REITs crashed by 18%. Had you simply ignored the growth and focused on your income instead, none of that would have mattered much to you. That's why it pays to stick with properties that can generate steady earnings from rental fees, like office space, apartment buildings, and warehouses. For instance, Christopher Marinac, a real estate analyst for Robinson Humphrey, likes Cousins Properties of Atlanta, which focuses on old faithfuls like offices and medical facilities. Although it yields only about 4.6% now, Marinac expects Cousins to increase its dividend soon to maintain the payout level required to remain a REIT in the eyes of the IRS.

--Convertible bonds. You really want to limit risk? How about an investment that has weathered the only full-fledged bear in a major market in recent history?

Convertible bonds are low-yielding corporate bonds that can be swapped for a specified number of common shares in the issuing company. As a result, a convert's price will rise more or less with that of the underlying common, but below a certain point it will take on a bond's downside protection. So while a convertible may capture only, say, 80% of its underlying stock's upside, it will suffer a mere 40% of any slide. According to a study from Ibbotson Associates, from 1973 to 1992--a period that included several bear markets--U.S. convertibles beat U.S. common stocks by almost half a point a year. Nick Calamos, who co-manages $3.9 billion for Calamos Asset Management, found that in the Japanese market between 1978 and 1996--a period that included a barn-burning rally and, since 1990, an ongoing vicious bear--convertibles returned an annual average of 9.03%, vs. just 7.66% for the Nikkei stock index. In fact, Calamos points out, "the Japanese convertible market today is 40% to 45% above its 1989 peak." The Nikkei? Off 53%.

Of course, convertibles are not risk-free. Smaller and sometimes shakier companies tend to issue them because it's one of the cheapest kinds of debt. Furthermore, many convertibles are available only to institutional investors. That's why it makes sense simply to buy a good fund. Though the choices are limited, a few funds have held up quite nicely over the years. Among them: Nicholas-Applegate Convertible, which topped all other convertible funds with a 22.9% return over the three years ended in June, and Calamos Growth & Income, which pumped out 20.9%.

--Fixed income. That brings us to actual bonds. No matter how much people like to knock them, bonds are the only investments that aim to return your principal intact while also promising a particular return. And even the most stock-obsessed financial advisers suggest that after you retire--or maybe even before--you should keep at least 30% of your portfolio in bonds. As legendary manager Bill Gross of PIMCO Total Return fund puts it in the wake of this decade's incredible stock market rally: "Good Lord, let's protect some principal!"

What's more, while bonds and stocks have typically mirrored each other's performance over the past 44 years, a study by Oppenheimer Funds indicates that this trend has begun to change. Since 1998, weekly returns of the S&P 500 and ten-year Treasury bonds have parted ways. The last time that happened in a big way was also the last time we had a spell of such low inflation: the 1960s. Oppenheimer analyst Robert Robis expects the recent trend to go on as inflation fears continue to abate.

Of all debt, Treasury bonds offer the most foolproof protection. They're not only incredibly liquid--after all, they're part of a $3.25 trillion market--but they're also backed by the full faith and credit of the federal government. So unless the U.S. suddenly collapses, you'll get your money back (though inflation will have eaten into part of its real value).

The safest method of investing in Treasuries is to build a laddered portfolio--a series of bonds with staggered maturities. For instance, buy a basket of Treasuries and put equal amounts in securities ranging from one- to ten-year maturities. When the one-year bill comes due, reinvest it in a new ten-year. That way, if rates rise (as they have this year), you capture the higher yield.

That's all very nice and safe, but many bond types would argue that you're better off taking a little risk in areas with sexier yields, like high-grade corporate debt or even junk bonds. In fact, over the past few months these securities have been offering delicious yields even for paper of decent credit. The Merrill Lynch corporate bond index now yields fully 1.13 percentage points more than Treasuries, 0.37 of a point more than last year. (In the bond world, that's a big jump.) Last fall corporate rates shot up when investors fled the world financial crisis, and even though the underlying corporations have strengthened along with the economy, rates have continued to hover at levels more appropriate for riskier holdings. The Strong Corporate Bond fund offers one great way to get in on those higher rates without delving completely into junk. Lead manager John Bender has churned out a three-year annual return of 8.5% by taking on triple-B bonds, the highest-yielding bonds that still qualify as investment grade.

Worried about taxes? Load up on municipal bonds, which are exempt from federal taxes and applicable state and local taxes. Though you lose on the yield, the tax protection can more than make up for it for anyone living in tax hells like New York. Let's say you're in the 33% combined federal and state tax bracket: You would need to get at least 7.13% on a taxable bond to pocket as much after taxes as you would with a muni yielding 4.78%. Vanguard offers reliable funds from California, Florida, Massachusetts, New York, New Jersey, Ohio, and Pennsylvania. The funds have no loads and minimal expense ratios of around 0.20--an essential factor, considering the low returns.

You may decide to avoid buying mutual funds altogether and purchase your bonds individually. The advantage of buying bonds outright is that (barring an unlikely default) you'll get your full principal and interest payment at maturity. Not so with a bond fund, which never matures.

But watch out. Buying individual municipals or corporates can be incredibly complicated. For one thing, it's expensive: A round lot costs at least $10,000, and in order to properly diversify you'll need close to $1 million. By contrast, you can get into a bond fund for only $2,000 or so. What's more, brokers make their money by adding hidden markups to individual bonds. Costs get steeper if the bonds are riskier or less liquid or if you're buying fewer of them. True, you have to pay annual expenses for a fund, but at least you'll know how much you're shelling out.

If you want to get all your bond exposure in one place, try PIMCO Total Return, the largest, most famous bond fund around, which boasts a three-year return of 8.3%. While its minimum is $5 million, you can go in via Charles Schwab or Waterhouse Securities for just $2,500 or $1,000, respectively.

Maybe the best way to think of income investing is as a fallout shelter that protects at least a portion of your money from any unforeseen disaster. And the rest of your savings? Throw it into stocks. That way you can act like Ted Giuliano's wife and take someone special out to a nice dinner.