Income: Why Cash Could Be King

Looking for the highest, safest yields? You may want to open a savings account

There's no question that income is an important piece of the investment puzzle. But where's the best place to get it in 2007--bonds, stocks, or cash?

You can't look to the financial markets themselves for guidance, since they're sending decidedly mixed signals. Consider the schizophrenic bond market. In corporate bonds, the yields of high-grade issues and junk aren't all that different. Such ultratight spreads typically indicate that investors are optimistic about corporate profits. Yet at the same time, rates on long-term U.S. Treasury bonds are lower than rates on short-term notes, a situation that has presaged each of the six recessions in the past 37 years. "The government bond market is signaling a massive slowdown, while the credit market is saying everything is fine," says James Swanson, chief investment strategist for MFS Investment Management.

With so much confusion out there, cash might be one of the best income wagers for 2007. It's among the safest investments around, and rates are fairly generous at the moment: Many high-interest savings accounts and money-market funds are yielding 5% or more. Compare that with roughly 4.49% to 4.66% for U.S. Treasuries across the spectrum of maturities. You're not likely to find the best rates at your local bank, so do a little comparison-shopping at a site such as

Among the best deals: HSBC Direct (HBC ) and Citibank (C ) offer online accounts with no fees, no minimum balances, and an annual percentage yield of around 5%. Mutual-fund shops Vanguard Group Inc. and TIAA-CREF have money-market funds with rates of 5.1%. Of course, savings accounts and money-market funds move up and down with rates (although money-market funds tend to lag a bit more). If you want to lock in a rate, buy a certificate of deposit (CD). CDs at ING Direct, (ING ) which come in terms of six months to six years, boast yields of 5% or more.

FOR A LITTLE EXTRA juice, check out bank loan funds, which invest in floating-rate corporate loans issued by banks or other financial institutions. The rates on such investments move up and down with short-term interest rates; right now the average is around 7%. The extra yield compensates for added risk: These loans are usually below investment grade or not rated at all. Floating-rate loans are strong performers in rising-rate environments, as we've had in the past year. But they're also a good call in times like now--when riskier, long-term junk issues have similar yields.

Morgan Stanley Prime Income Trust (XPITX ) boasts a yield of 6.7%. Its managers favor companies with hard assets and good cash flows backing their deals, qualities that help mitigate the credit risk. You'll get a slightly lower yield of 5.99% from the Fidelity Floating Rate High Income Fund. But the no-load portfolio, which mostly owns the loans of large companies and keeps a nice stash of cash on hand, is one of the highest-quality and lowest-cost portfolios in the group.

The high-grade corporate bond market is a bit treacherous at the moment. Private equity funds have billions of dollars at their disposal, money they're using to buy out companies and pack them to the gills with debt. That's an especially hazardous scenario for bondholders of investment-grade corporates. Surprisingly, the owners of junk bonds usually have more protections in such situations. On buyout news at Clear Channel Communications Inc., (CCU ) the yields on some of its older bonds zoomed as the price dropped precipitously. "[LBO risk] is a real and present danger from a bondholder's perspective," says Thomas H. Atteberry, co-manager of FPA New Income Fund, which has a 4% weighting in corporate bonds right now, in part because of such risks.

Investors can find shelter in the highest-quality bonds of large banks, insurers, and utilities, since such businesses are rarely private equity targets. But for extra yield, consider preferred stocks, which trade on exchanges but pay out a fixed interest rate like a traditional corporate bond. Right now, investors can find yields of 6% to 7% on a high-quality preferred stock, compared with 5% to 5.5% for similar corporate bonds. A recent 30-year issue from Citigroup (C ) that was callable in five years had a yield to maturity of 6.45%. Closed-end funds that specialize in preferred stocks can amp up yields. Look for funds that trade at a discount to their net asset value, such as BlackRock Preferred Income Strategies Fund (PSY ) (6.86% yield) and Nuveen Preferred & Convertible Income Fund (JPC ) (7.48% yield).

DIVIDENDS SHOULD BE PLENTIFUL in 2007. Flush with cash, many companies have been steadily increasing their payouts. The Standard & Poor's 500-stock index now has a dividend yield of 1.8%, compared with 1.12% in early 2000. The 15% tax rate on most dividends is a nice bonus, one that Congress isn't likely to change in the near future. "In the past, if you paid a dividend it was almost a sign of weakness that you couldn't find something better to do with the money," says John Buckingham, manager of the Al Frank Dividend Value Fund (VALEX ). "There has certainly been an increase in the desire to reward shareholders with dividends."

You can find nice dividends in practically any sector of the market. The usual suspects--financials, pharmaceuticals, and utilities--offer some of the fattest. Large money center and superregional banks, which have underperformed their smaller, localized brethren, offer a nice combination of a value price and a regular dividend check. At a recent price of 35.50, Wells Fargo & Co. (WFC ) had a reasonable price-to-earnings ratio of 14 and a solid dividend yield of 3.05%. U.S. Bancorp (USB ), which is considered a potential takeover candidate, currently yields 3.88%.

MANY DRUG STOCKS YIELD around 3%. But investors with a bit more tolerance for risk might consider Pfizer Inc.'s (PFE ) dividend yield, which is closer to 4%, and its potential for price appreciation. After the pharmaceutical company pulled a major drug from its pipeline, the stock took a hit, falling from 28 to 25 by mid-December. Pfizer, with a p-e ratio of 12, is cheaper than it has been since the Hillary Clinton health-care initiative more than a decade ago. Contrarians figure that Pfizer's p-e should be closer to 17 once its gets through this bad patch, pushing the stock up to 35. In the meantime, says Bart Geer of Putnam Equity Income Fund (PEYAX ), "investors are being paid to look over a valley."

One surprising place to find dividends is technology companies, which also offer the lure of strong growth potential. Mega-cap names such as Microsoft Corp. (MSFT ) and Intel Corp. (INTC ) offer puny payouts. But small, cash-rich companies have been rewarding their shareholders handsomely. Online direct marketer Traffix Inc. (TRFX ) has a 6.05% yield, while memory-chip maker Dataram Corp. (DRAM ) yields 5.7%. In the telecom arena, Verizon Communications Inc.'s (VZ ) yield recently hit 4.54%. Of course, these aren't your usual stodgy dividend payers; high tech comes with high risk.

For a basket of diversified dividend payers, the best way to go is an exchange-traded fund (ETF) or a mutual fund. The iShares Dow Jones Select Dividend Index (DVY ), which owns more than 100 of the market's top payers, had a recent yield of 3.1%. Thornburg Investment Income Builder Fund (TIBAX ) has 40% of its money overseas, where dividends tend to be fatter than in the U.S. The fund's yield is a lip-smacking 3.74%. In today's perplexing income environment, that's a big difference.

By Adrienne Carter

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