The Search For Yield With the bond market peaking, investors looking for income need to get creative.
By Yuval Rosenberg

(FORTUNE Magazine) – At a Chase bank branch on Manhattan's East Side, information-desk staffer Inez Cash can't keep from laughing when quoting the yield on certificates of deposit. Six months gets you 1.10%, for example. "Bad, right?" she says, chuckling. Very bad. What's more, the yields on other fixed-income investments look similarly laughable.

A three-year-long bull run on bonds has picked up steam of late, with investors pouring a record $45.3 billion into bond funds in the first quarter of 2003. That has pushed prices higher, but it has also left yields excruciatingly weak: Treasury-bond payouts are hovering at lows not seen in more than 40 years.

Traditionally, investors looking to crank up their cash flow might move to longer-term bonds with higher returns. But yields there have been hammered too, and long bonds bring with them an added risk: When interest rates rise, their value drops more sharply than with shorter-term investments. So what's an investor with a yen for yield to do? FORTUNE put that question to a host of analysts and money managers and found a few pockets of potential for fixed income.

For investors willing to live with higher volatility, money managers suggest tiptoeing, ever so carefully, into the world of junk bonds. Bond buyers have been flocking to high-yield funds since last October, and inflows in the first quarter of 2003 reached $11 billion, compared with $11.7 billion in all of 2002. As a result, yields are down from recent highs. But with payouts about 7.5% more than for comparable Treasuries, junk yields still stand some 2% above their historical premium. If corporate earnings don't recover much, high yield will be choppy. But high-yield funds don't carry the same concerns that plague their investment-grade counterparts: "They represent a bit of a safe haven from rising rates," says Morningstar analyst Bradley Sweeney.

The Pimco High Yield fund (PHDAX) is one way to explore the junkyard without rummaging through the riskiest offerings. "They really are well diversified, and they typically try to stick with the highest quality among the universe of high-yield bonds," says Jack Ablin, chief investment officer of Harris Trust and Savings Bank. Pimco's fund, with assets of about $5.8 billion and a 0.9% expense ratio, has nearly a third of its assets in BB-rated bonds, the highest grade of junk. That approach garners a yield of 7.41% and has returned a total of 6.5% so far this year. A no-load alternative, the T. Rowe Price High-Yield fund (PRHYX) is a diversified mix of holdings with a reasonable 0.83% expense ratio. The portfolio takes on more credit risk, but it also now carries a 9.25% yield and a total return of nearly 8% so far this year.

While junk-bond funds may appeal to yield-hungry investors with strong stomachs, there are other, less risky ways to add some income to your portfolio. One very safe suggestion: Treasury Inflation-Protected Securities, or TIPS, which provide a guaranteed payout above the inflation rate. Ten-year TIPS, for example, have a yield of about 2% above inflation. "It's not too sexy, but if people are looking to diversify their portfolio and sleep at night, it's one of the highest rates available," says Standard & Poor's analyst Gary Arne. TIPS can be bought directly from the U.S. government, but they are also available in funds. The Pimco Real Return Bond fund (PRTNX), for example, has about 90% of its $7.1 billion invested in TIPS and similar securities.

Morningstar's Sweeney also suggests that investors turn to municipal bonds. "A lot of investors may be surprised to find that municipal-bond funds make sense for them on an after-tax basis," he says. "In some cases they're offering higher absolute yields than taxable funds." Vanguard's Intermediate-Term Tax-Exempt fund (VWITX), which carries a low 0.17% expense ratio--a defining difference between winners and losers in muni investing--is one attractive option. A rise in interest rates could hurt any chance for eye-popping overall returns, but with yields above 3%--the equivalent of about 5% on a taxable fund--munis may still make sense, particularly for investors in the highest tax bracket. After all, finding a little extra cash these days is no laughing matter.