Income Investing: Don't Come Up Empty-Handed

It's hard to find fat yields in this arena, but here's a clutch of ideas

Looking for income in this interest-rate environment is frustrating. The yield curve is flatter than a pancake, so short-term rates on Treasuries are practically in line with long-term rates. And although many pundits agree that the Federal Reserve Board will modestly hike rates in the beginning of 2006, that gap is likely to remain pretty small. At the same time, there are a lot of uncertainties -- like inflation, the housing market, and foreign demand for U.S. bonds -- and all that is making the bond market skittish. "We're in the late stages of Fed tightening, which has a way of making the market kind of hazardous," says George Fischer, a bond fund manager with Fidelity Investments.

So what do you do for income? Since you're rarely rewarded in this market for taking on more credit risk, higher-quality fixed-income issues rule. That's true across the bond world. You need to consider mining the equity markets for yield, too. "You have to look at multiple sources, not just the standard instruments," says Scott Powell, managing director of Virchow Krause Wealth Management.

Considering that, we explored the entire spectrum of income-oriented investments. What follows are some of the best opportunities in a market that's not all that rewarding.

>> SHORT-TO-INTERMEDIATE INVESTMENTS These days you won't get much bang from a bond with a longer maturity. In fact, there is essentially no gap between the yield on the two- and five-year Treasuries, with both at around 4.4%. A 30-year bond offers only an extra 0.30 percentage points.

Given that, it makes sense to stay on the shorter end of the maturity spectrum and in high-quality securities from top-drawer borrowers. "This is an environment where income investors don't want to do anything too heroic," says Warren D. Pierson, senior portfolio manager at Robert W. Baird & Co.

Buying individual Treasuries is simple and a virtually cost-free way to invest in the shorter end. But use mutual funds if you want to invest in corporate income securities. By doing so, you'll avoid the risk that company-specific news sends your investment reeling, such as the financial woes at Ford Motor Co. (F ) and General Motors Corp. (GM ). One approach is a mutual fund like Metropolitan West Total Return Bond Fund. It includes U.S. government, corporate, and mortgage bonds, and has a duration of 3.9 years -- meaning that the fund will decrease in value by roughly 3.9% if interest rates rise by 1% and increase 3.9% if rates do the reverse. That compares with a duration of 4.6 years for the Lehman Brothers U.S. Aggregate Bond index. Management has also limited the interest-rate risk by owning a number of less interest rate-sensitive investments like bank loans. The fund yields 5.87%.

Even a bank certificate of deposit can be attractive. You won't necessarily find the highest yield at your neighborhood branch, so compare rates at a site like Bankrate.com (RATE ). A one-year CD at Corus Bank in Chicago recently had a rate of 4.75% vs. a 4.11% national average.

>> MUNICIPAL BONDS Foreign investors have been gobbling up long-term U.S. Treasuries, helping keep prices up and yields down. But they buy municipals, a sector dominated by individual investors seeking the tax-free income. That's one reason why muni yields haven't moved in tandem and thus look better on a tax-equivalent basis. A 10-year insured muni yields 4.04%, vs. 4.55% for a 10-year Treasury. For an investor in the 28% tax bracket, that's like earning 5.61% on a taxable bond. Assuming a 35% tax rate, the equivalent yield jumps to 6.22%.

The same advantages hold true with muni bond funds. Vanguard Intermediate-Term Tax-Exempt Fund and USAA Tax Exempt Intermediate-Term Fund have current yields of 4.06% and 4.17%, respectively. The tax exemption boosts those numbers to 6.25% and 6.42% for top taxpayers. Closed-end funds offer even potentially higher rewards, 5% to 6% tax-free. But such funds often use leverage, borrowing money to buy more and enhance yields. So higher short-term rates can crimp a fund's ability to keep up that dividend.

As with most closed-end funds, buy only when it trades at a discount to the value of its holdings, or net asset value (NAV). Managed Municipals Portfolio (XMMUX ), run by bond veteran Joseph Deane, is a high-quality offering and trades at a 10.93% discount. Nuveen Quality Income Municipal Fund (XNQUX ) has an 8.65% discount and a 6.02% yield.

>> BANK LOAN FUNDS You can get yields of around 5% in a bank loan fund, which buys floating-rate corporate loans. The interest rates on the loans move up and down with short-term rates, so the funds' NAVs are fairly stable.

Given the recent moves by the Fed, the yields on bank loan funds are at their highest level in years, and they're fatter than those of money-market funds and ultra-short bonds. The extra yield, though, comes from credit risk. The loans in these funds are typically not rated or rated below investment grade.

Fidelity Floating Rate High Income Fund (FFRHX ), which is yielding 4.90%, is among the highest-quality offerings. The no-load fund invests mainly in the loans of larger companies, and it keeps a nice stash of cash for liquidity. Eaton Vance Floating- Rate Fund, at 5.12%, has one of the most seasoned management teams in the field.

The sector has had a nice run in the past few years, so don't bank on price appreciation to boost returns. If the Fed stops hiking rates, the funds' yield will stop going up. Still, says Morningstar Inc. (MORN ) analyst Scott Berry, a bank-loan fund "is a good balance to a high-quality, interest rate-sensitive portfolio."

>> DIVIDEND-PAYING STOCKS Many companies have record stashes of cash, and shareholders want more of it. Some CEOs and boards are listening, upping their dividends or offering one for the first time. According to Standard & Poor's (MHP ) (like BusinessWeek, owned by The McGraw-Hill Companies (MHP )), 280 companies have increased their dividend so far this year, up from 272 in 2004.

What's more, we could see even higher payouts, according to Duncan W. Richardson, chief equity investment officer for mutual fund firm Eaton Vance (EV ) Corp. The typical company in the Standard & Poor's 500-stock index pays out one-third of a historical 50%. That means there's room to hike the payouts.

Today, it's not hard to find dividend yields of 3% to 5% on blue-chip companies. Megabanks such as Citigroup Inc. (C ) and Bank of America Corp. (BAC ) yield 3.62% and 4.15%, respectively, well above the S&P 500's 1.78% average. Battered pharmaceutical stocks also look appealing, says John Buckingham of the Al Frank Funds. On top of their yields, their low prices mean many have the potential for decent capital appreciation -- giving them a heftier overall return. Pfizer (PFE ), for instance, yields 3.62% and just announced a 26% dividend increase.

A good way to get a diversified portfolio of dividend payers is through an exchange-traded fund. The iShares Dow Jones Select Dividend Index Fund owns roughly 100 of the market's biggest payers, with a heavy dose of financials, pharmaceuticals, and utilities. Its recent yield was 3.9%. The brand-new SPDR Dividend ETF owns top-paying companies that have consistently increased their payouts. It tracks the S&P High Yield Dividend Aristocrats index, which yields 3.3%.

>> OPTION INCOME FUNDS It's pretty rare to find yields of 8% to 10% in this market. But for investors who are willing to take on more risk, option income funds are a good choice. These largely closed-end funds employ what's known as a covered-call strategy, buying stocks and then selling options on those stocks for which they receive a payment. Today, many sell at a discount to their NAVs.

Such discounts aren't the result of poor performance, says Mariana F. Bush, a fund analyst at Wachovia Securities LLC (WB ), but rather the flood of new funds on the market and investors taking yearend losses. Eaton Vance Enhanced Equity Income (EOI ) and NFJ Dividend, Interest & Premium Strategy Fund (XNFJX ) have sizable discounts, and have yields of 8.69% and 9.86%, respectively. BlackRock Global Opportunities Equity Trust (XBOEX ) trades 6.3% below its NAV and has a yield of 10.33%.

To get that extra yield, investors give up some upside potential. So performance may lag behind traditional stock funds if the market rallies. Even though the income makes them less volatile than most equity funds, they're not immune from bad stock selection.

>> INCOME DEPOSIT SECURITIES/INCOME TRUSTS An up-and-coming investment idea, Income Deposit Securities (IDSs) offer yields of up to 14%. IDSs are part stock and part bond. That means roughly half the yield comes from the stock dividend, which is taxed at the maximum tax rate of 15%. The remaining portion comes from bond payments, taxed at your regular income tax rate.

Right now, most Income Deposit Securities are issued by small but cash-rich companies, says Neil George, editor of Personal Finance, an investment newsletter. The yield on OTELCO Inc. (OTT ), a rural phone company, is just north of 10%. Centerplate Inc., which runs concession stands at sports stadiums and other venues, pays 13.22%.

There's another opportunity to pick up yields higher than 10%, up north with Canadian Income Trusts. These trusts pay out a large chunk of their earnings, usually on the order of 60% to 80%. Like an IDS, income or royalty trusts tend to be from cash cows, typically in the natural resources sector. For example, ARC Energy has a dividend of 8.84%, while NAL Oil & Gas pays 12.2%. You can find some outside of energy, including beermaker Big Rock Brewery (7% yield) and trucking and logistics company TransForce (7.73%). In today's yield-starved market, they are filling fare.

By Adrienne Carter

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