Investment-grade bonds, especially those issued by financial companies, are looking better. By James K. Glassman, Contributing Columnist From Kiplinger’s Personal Finance, February 2013 We’re not asking for much. Earning a 5% yield would be nice. Heck, we’d settle for 4%. But current opportunities for income appear far stingier. What’s an investor to do? SEE ALSO: Our Investing Outlook for 2013 Look at the numbers. The quintessential low-risk vehicle, a five-year Treasury note, combines a relatively short term with the sound credit of the U.S. government and yields a meager 0.6% at a time when the annual rate of inflation is 2.2%. So if you invest $10,000, you’ll be repaid at the end of five years in currency with the purchasing power of just $8,947 in today’s money. The interest you’re paid, even reinvested annually at the same rate, will amount to only $304, so you’ll be $749 behind. Long way out. To achieve an annual income from a Treasury bond that matches the current inflation rate, you have to postpone maturity until 2031. By contrast, the income return on intermediate Treasuries has exceeded 4% in 40 of the past 50 years, according to Morningstar’s Ibbotson unit. Advertisement You can get interest of 2.7%, if you’re willing to accept a 30-year maturity. But if you buy such a bond, you are taking on the risk that consumer prices will rise at a faster rate in the future or that investors will become more skittish about debt issued by Uncle Sam. Or both. These risks are real. There’s a time-honored tradition for nations to inflate their way out of debt, and you can certainly imagine America’s creditors growing tired of stashing cash in a supposed safe haven that’s running annual deficits of a trillion bucks and up. In either case, it’s a decent bet that interest rates will rise over the next decade as investors demand more income as compensation. If you buy a ten-year Treasury paying 1.6% today, and if rising inflation pushes rates to 3% in the next two years, then your bond will fall sharply in attractiveness—and in price. The prospect of higher rates tomorrow makes stingy yields now an even bigger problem. If you think rates will rise, then you should opt for shorter maturities; if you own a bond that matures in, say, two years rather than ten, you can wait until you’re repaid and then use the cash to buy a bond that pays more. But a two-year Treasury is yielding just 0.3% right now. Meanwhile, money-market funds pay virtually nothing, and one-year, insured bank certificates of deposit are averaging about 0.3%. So forget all those. The formula for a sustainable stream of 4% income today involves a mix of four other elements. Sorry, I can’t make it simpler. Each of the securities below is riskier than U.S. government–insured assets, but the ultimate payoff is worth the modest gamble. And you can reduce your risks by diversifying. Advertisement Municipal bonds. The debt of state and local governments generally pays interest that is exempt from federal taxes. Yields vary widely depending on maturity, the borrower’s credit rating and the source of the money for debt service. The state’s taxing power stands behind general obligation, or GO, bonds, while specific streams of cash, such as turnpike tolls, support revenue bonds. For instance, a Massachusetts Bay Transportation Authority revenue bond maturing in 2037 yields 2.9%, which is equivalent to a taxable yield of 4.5% for someone in the 35% federal bracket. To get such yields, you have to buy long-maturity bonds, but I would not hesitate to do so; short-term munis are absurdly parsimonious. I would also feel confident about a long-term GO from California (recently yielding 3.5%) or even Puerto Rico (4.1%), which is a bit riskier than most states. There is some uncertainty about munis, however. It’s possible that tax reform will limit or even eliminate the muni-interest exemption. But tax rates could also rise. If the top bracket goes to 40%, then a 3.5% yield would be equivalent to a taxable 5.8% for a top-bracket taxpayer. My own guess is that although reform legislation may cap the state income-tax deduction, it won’t affect munis. A good strategy is to buy a few higher-yielding, longer-term munis plus a fund such as Fidelity Tax-Free Bond (symbol FTABX), which owns a high-quality portfolio (two-thirds of its holdings are rated double-A or triple-A for creditworthiness) with short-, medium- and long-term maturities and sports a 1.9% yield, the equivalent of 2.9% if you’re in the 35% tax bracket. Junk bonds. In the April 2012 issue, I wrote enthusiastically about corporate high-yield, or junk, bonds—that is, securities rated below triple-B. The junk funds I recommended have done well: Vanguard High-Yield Corporate (VWEHX), for example, has generated a total return (interest payments and price appreciation) of 16.0% over the past 12 months. Unfortunately, junk bonds have proved so popular that the fund’s yield has dropped from 5.8% to 4.9%. Advertisement Smart investors, including mutual fund managers, have been buying up the debt of companies that are just below investment grade, so yields for those bonds aren’t as attractive as they were. You have to take on more risk for a decent reward. A good example is a Beazer Homes USA bond maturing in May 2019, rated CCC by S&P and sporting a current yield of 7.4%. Unlike many other homebuilders, Beazer is still losing money, but I think the debt is a good play. The firm owes $1.5 billion, but, with $800 million of cash on its balance sheet, it’s not running out of money anytime soon. Again, for this part of the portfolio, buy a fund and a few higher-risk individual bonds with maturities in the range of five to ten years. Financial-company bonds. Investment-grade bonds, especially those issued by financial firms, are looking better. For example, Goldman Sachs debt that’s rated A– by S&P and due in January 2022 recently yielded 3.4%; Morgan Stanley bonds, rated slightly lower and maturing about the same time, yielded 4.5%. Again, you’ll want to diversify and further mitigate risk by buying higher-quality and shorter-maturity bonds. T. Rowe Price Corporate Income (PRPIX) is a good bet among mutual funds, with a solid portfolio and an average maturity of just nine years. Its 2.5% yield doesn’t dazzle, but combined with equal doses of the Goldman and Morgan bonds, you get an average yield of 3.5%. Stocks. With a bond, a business promises to repay what you invested, plus pay interest along the way. With a stock, neither the repayment nor the dividend is certain. Still, if you buy shares of sound companies, both are highly likely. Stocks with high dividend yields are the best bargain in the income world today. The 30 companies of the Dow Jones industrial average yield an average of 3.0%. That’s as much as a 30-year Treasury bond, a true modern anomaly. Between 1958 and 2009, the yield on a five-year T-note exceeded the average yield on Standard & Poor’s 500-stock index. Today, the index yields 2.3% and the five-year note, as I said earlier, just 0.6%. A lot of strong companies are yielding 3% to 5%: Procter & Gamble (PG), consumer products, 3.2%; Merck (MRK), pharmaceuticals, 3.9%; Southern Co. (SO), utilities, 4.5%; Microsoft (MSFT), software, 3.5%; Intel (INTC), semiconductors, 4.6%; ConocoPhillips (COP), energy, 4.6%; and RPM International (RPM), specialty chemicals, 3.1%. Add some solid real estate investment trusts for good measure: Washington REIT (WRE), 4.6%, and Vornado Realty (VNO), 3.6%. Advertisement I have long been a fan of SPDR S&P Dividend (SDY), an exchange-traded fund that owns the 50 highest-yielding stocks in the S&P Composite 1500 index (an index that includes stocks of small and midsize companies as well as the larger companies in the S&P 500) that have increased their dividends for at least 25 years in a row. The ETF is currently yielding 2.9%. One risk is that the top tax rate on dividend income could double, or more, under a new tax law, so you may want to put high-yielding stocks and funds in an IRA or 401(k). To get to 4%, put one-fourth of your portfolio into each of the four categories. What about getting to 5%? You can get close, but don’t be greedy. Interest rates are likely to rise -- thanks to inflation, nervousness about credit quality, or (more optimistically) increasing demand by companies for debt as business improves. As you put new money or the proceeds from maturing bonds into income-producing assets, the yield on your overall portfolio will rise. Right now, however, reaching for higher yields is foolhardy. Be happy with 4%-plus. And wait. James K. Glassman is founding executive director of the George W. Bush Institute and author of Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence. He owns none of the stocks mentioned. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!