Yield of Dreams In an uncertain market, dividends can make the difference. Here are 15 ways you can boost your investment income.
By Yuval Rosenberg

(FORTUNE Magazine) – There's nothing like money in the bank. That's why many savvy investors look to lock in a certain amount of yield when they're designing a portfolio, no matter the market cycle.

Socking away--or reinvesting--those quarterly checks is not only comforting, but during downturns it often makes the difference between getting by and meeting your goals. In an iffy market, the guy with the most percentage points usually wins.

Finding ways to boost your investment income is particularly important right now. After a powerful rally last year, stocks have languished for the first six months of 2004. Even after weeks of solid gains, in mid-June the S&P 500 was up a ho-hum 2% and the Dow was down 0.6%. What's more, while stocks are flat, interest rates are rising. Stir in economic and political uncertainties and you can see why a number of Wall Street pros have tempered their expectations for the market. And although rising rates mean that Treasuries and money market accounts will finally start paying out more, they also undercut bond prices.

Given those challenges, FORTUNE went in search of sensible ways to boost income across a range of asset classes. Here are our best picks.

Dividend-paying stocks

In equities, income generally means dividend-paying stocks, and history shows just how valuable these payouts can be. From 1926 through 2003, dividend payments accounted for just over 41% of the S&P 500's total return, according to Ibbotson Associates. Think about that: For the better part of a century, well over a third of investors' takeaway from equities has come from dividends. And while yields don't regularly top 4% as they did before the '60s, they still account for a large portion of the market's gains--about 22% from 1984 through last year. Yet investors showed little regard for dividends in the late '90s. Even last year investors chose to chase quick profits by plowing money into shares of the kind of high-risk companies that typically don't distribute income back to shareholders.

That's changing. As the economic rebound solidifies, investors have been rotating out of speculative investments and shifting into stable, dividend-paying stocks. Last year's tax cut, which reduced the maximum levy on dividends from 38.6% to 15%, is encouraging the trend. Through the end of May, 130 companies in the S&P 500 index had boosted their dividends since last year, up from 99 over the same period in 2003. And so far this year, dividend-paying companies in the S&P 500 have gained 5.1% on average, whereas non--dividend payers are up 4%.

Still, it pays to be choosy; sky-high yields are often the product of a falling stock price. "The highest-yielding investments in any industry are typically a bad investment--an indication that the dividend's about to be cut or that the stock price is depressed because the company is having problems," says Alan Skrainka, chief market strategist at Edward Jones.

To find income-generating stocks that can deliver healthy returns, we looked for companies that have both consistently grown earnings and raised distributions. Since 1974 companies that introduced or increased dividends have returned 11.8% annually, compared with 11.4% for all dividend payers and 6.6% for non--dividend payers, according to Ned Davis Research. Then, after consulting with market strategists and portfolio managers--and sifting through financial statements--we settled on seven individual equities and four funds.

One name that jumped out right away was that of consumer products giant Procter & Gamble (PG, $56). P&G, it turns out, is a dividend investor's dream. The maker of Crest toothpaste, Ivory soap, and Bounty paper towels has boosted its earnings per share at a 9% compound annual rate over the past five years--and raised its dividend for an astonishing 48 straight years. One caveat: Its stock, up 11% this year, now trades at a less-than-cheap 24 times projected 2004 earnings.

Another blue chip with a rich dividend history is pharma powerhouse Pfizer (PFE, $35), with a 37-year record of raising payouts. The drugmaker also has a stable of nine billion-dollar drugs, projected earnings growth of 20% for 2004, and a solid pipeline of new products. Pfizer's stock trades for less than 17 times its expected 2004 earnings per share, compared with an average of 19 times for the industry.

Then there's Exxon Mobil (XOM, $45), which has upped its dividend payment for 22 years running. Shares of the oil services behemoth trade at just 15 times its projected 2004 earnings. With higher oil and gas prices driving profits, Exxon should be in a good position to continue sweetening its payout.

Financial stocks are widely expected to take a tumble as interest rates rise. Yet they've held up fairly well during some previous periods of Fed tightening --even outperforming the S&P 500 in the six months after the Fed hiked rates in 1994. And not all financials carry the same rate sensitivity. Take Wells Fargo (WFC, $59), for example. "They just have a great collection of businesses that operate at a very low cost," says Todd Ahlsten, manager of the Parnassus Equity Income Fund, which has an annualized return of 8.5% over the past five years. Wells Fargo has rewarded shareholders by increasing its dividend for each of the past 16 years. Right now it trades at 14 times its projected 2004 earnings.

Untainted by the mutual fund scandal, money manager T. Rowe Price Group (TROW, $48) may actually have benefited from its rivals' woes: It reported inflows of $6 billion in the first quarter of 2004, up some 50% from the previous year. "No matter what the interest rate environment is, people are putting money into their 401(k) plans," says Joseph Lisanti, editor of The Outlook, S&P's investing newsletter. Profits at T. Rowe spiked during the tech boom, then fell back with the market's collapse. Since 2002 the firm has been back on the growth track. Analysts expect the company to earn $2.48 a share this year, up from $1.77 in 2003. T. Rowe has increased its dividend 485% over the past decade.

Cedar Fair Limited Partnership (FUN, $33) knows a thing or two about roller coasters, but you wouldn't know it from looking at its stock chart. Since its 1987 public offering, the theme park operator has had average annual total returns of 20% (with dividends reinvested). A falloff in attendance, combined with increased expenses, caused Cedar Fair's profits to dip in 2001. But while competitors like Six Flags have struggled over the past few years, Cedar Fair has managed to rekindle its earnings growth. For 2003, earnings per share rose 15%. Because the theme park operator is a limited partnership, its payout is taxed as regular income, and individual investors must include a special form with their yearly filings. But Cedar Fair has raised its dividend for 17 straight years. And with its current yield of 5.5%, there will be plenty left over for investors after tax day.

Any discussion of income-producing investments has to include real estate investment trusts (REITs). Because they are required to pay out at least 90% of their profits, these companies offer some of the highest yields around. (As with limited partnerships, though, the payouts are taxed as regular income.) After outperforming the market for the past four years, REITs were pummeled early this spring because of their interest rate sensitivity. But many analysts remain bullish on mall REITs. They expect growth in consumer spending to continue, boosting profits for shopping center operators such as Mills Corp. (MLS, $47). Mills, which has pulled back about 16% from its 52-week high of $54, right now has a generous yield of 5.2%.

For investors who aren't comfortable putting their money into individual stocks, a good way to bet on dividends is to invest in an equity-income or dividend growth fund. These funds typically load up on undervalued stocks with significant cash distributions. And the best ones don't cut into your take with fees. "It's very difficult for a fund to throw off a lot of yield unless it has low expenses," says fund analyst Todd Trubey of research firm Morningstar. We picked three no-load funds with reasonable expense ratios. Vanguard Equity Income (VEIPX) has produced annualized returns of 11.5% over the past ten years, on a par with the S&P 500, and an average return of 2% during the past five years, four percentage points better than the S&P index. American Century Equity Income (TWEIX) has gained 14.5% a year since the fund's inception in 1994. Managers Phil Davidson and Scott Moore also mix in a smattering of preferred stock and convertible bonds to pump up the portfolio's yield (now 2.4%). Likewise, the team that runs Dodge & Cox Balanced (DODBX) blends stocks and bonds to produce a yield of 2.1%. They've beaten the S&P by an average of more than 11 percentage points annually over the past five years.

Our final equity pick is iShares Dow Jones Select Dividend Index (DVY). Introduced last November, this exchange-traded fund has a rock-bottom 0.40% expense ratio, and holds 50 of the highest-dividend-paying stocks in the 1,634-company Dow Jones U.S. Total Market index. The fund includes only stocks that have grown their dividends over five years and pay out a maximum of 60% of earnings. A note of caution: The ETF has nearly 40% of its assets in financials, which makes it sensitive to interest rate hikes.

Bond strategies with a twist

With interest rates rising from a decades-long low, the outlook for bond investors is treacherous. The shift has already begun to shake up the market: From mid-March to mid-June, the yield on the ten-year Treasury jumped from 3.68% to 4.69%. As rates travel higher, bond prices, which move inversely to yields, will suffer. To be safe, financial advisors suggest sticking with short-maturity bonds and their relatively skimpy yields as part of a laddered portfolio. Then, as the bonds mature, take advantage of rising interest rates to load up on better-paying issues. "For now, stay short and give rates time to work through, and there will be another opportunity 12 to 18 months down the road," says John Schmitz, managing director of strategic income at Fifth Third Asset Management.

But for investors who are willing to get creative, there are still a few fixed-income investments that make sense. In fact, it's even possible to use rising interest rates to your advantage.

One credit class that should fare well in this environment is the so-called bank loan fund, also known as a loan-participation or floating-rate fund. These funds buy bundles of bank loans that typically have rates pegged to benchmarks such as the London Interbank Offered Rate (LIBOR) or the U.S. prime rate. The loan rates are reset regularly, so as interest rates climb, the yields from the funds climb as well. Those rising yields help make floating-rate funds less vulnerable to price plunges. "It's a great way to boost yield, get more income, and still maintain good, strong capital preservation," says financial advisor Gary Ambrose of Personal Capital Management in New York. The loans bought by these funds are made to companies with heavy debt or poor credit ratings, however, so they do carry some credit risk. Another downside: Most floating-rate funds are the closed-end kind that can be sold only on a monthly or quarterly basis. An exception is Fidelity Floating Rate High Income (FFRHX). This relatively new offering (it was launched in September 2002) not only offers daily redemptions but, with no load and an expense ratio of just 0.86%, is also cheaper than most of its competitors.

Adjustable-rate mortgage funds should also withstand rising rates. As their name suggests, these funds buy pools of adjustable-rate home loans. As with bank loan funds, yields on ARM funds climb along with the underlying loan rates. Those rates aren't reset as rapidly as with loan-participation funds, but the funds should face less credit risk than bank loan offerings. Many of the loans they buy are backed by government-sponsored agencies like Fannie Mae. We like the no-load AMF Adjustable Rate Mortgage (ASARX), which has an expense ratio of 0.44%, compared with an 0.8% average for its peers.

Investors who don't want to risk their principal and who are willing to invest their money in a less liquid fashion might also consider a stable value fund. These short-term bond funds, which are generally available only through retirement plans, come with insurance protection to keep the fund's net asset value constant. Our favorite, PBHG IRA Capital Preservation (PBCPX), holds only AAA-rated issues. (We are so confident about the security of this fund that we also picked it to stabilize our portfolio of top picks--see "The Fortune 40.")

Sitting on a hefty sum of cash? You should be cheering. The average yield on taxable money market accounts has lingered well below 1% for months. But as interest rates climb, bank rates will too, meaning you can finally expect to keep up with inflation. Until then, yields on bank holdings will be less than thrilling.

In the meantime, to get better returns on long-term savings, try the government's Series I savings bonds, which have a compound interest rate of 3.39%. That rate is made up of a fixed component, now 1%, and an inflation-adjusted component that is reset twice a year, so if inflation creeps higher, the payout will too. Even sweeter, I bonds are exempt from state and local taxes. You must hold them for at least a year, and if you cash out in less than five you'll incur a penalty of three months' interest. But if rates rise enough, "you can just choose to pay your three months' interest penalty and buy new bonds," says financial planner Ross Levin of Accredited Investors in Minneapolis. Either way, you'll probably be ahead of money market funds. And there's an extra dividend: You won't lose any sleep.