The Best Bets for Income in 2011

Bond investors will find the coming year challenging.

What's been bad for the unemployed and for Americans worried about joining their ranks has been a boon for bondholders. As yields fell in response to a tepid economy, bond prices rose across the board the past year. As a result, returns for almost every fixed-income category ranged from good to terrific. The leaders: long-term Treasuries, junk bonds and emerging-markets debt, which returned between 13% and 17% in 2010 (through November 5).

Bonds have performed so strongly that some analysts are describing the action in Treasuries as a bubble -- but not Phil Condon, head of municipal-bond management for DWS Investments, part of Deutsche Bank. Condon agrees that bond yields are more likely to rise than fall from today's current levels but, he says, "I don't agree with those who say there's a bubble in bonds as there was for the Nasdaq index or the housing market." In other words, you won't lose 50% of your money in bonds, "but investors could sure be disappointed" in 2011, he says.

Forecasting interest rates is especially difficult because of the combination of a slumbering economy and a Federal Reserve Board that is using every trick at its disposal to goose growth. Among other things, the Fed is essentially printing hundreds of billions of dollars, which it's using to buy Treasury bonds and bring down their yields. The Fed may succeed in the short term, but it runs a risk of stoking inflation over the long term. And inflation is the biggest enemy of bond holders.

Kiplinger's believes the Fed will leave short-term rates unchanged over the coming year (see Kiplinger's Economic Outlook). That means money-market funds and short-term CDs will continue to pay between nothing and next to nothing. We think long-term Treasury-bond yields could rise a full percentage point. If we're right, expect the price of the ten-year Treasury and funds that invest in bonds of that maturity to lose 9% of their value.

What to do? First, if you own long-term government bonds (directly or in a fund), or corporate bonds that sell for more than face value and can be redeemed for $1 on the dollar within three years, sell before your profits disappear. Next, to help you make decisions based on your needs, think about why you own income-paying investments. Here are three common reasons:

To preserve capital. A good strategy is to invest in a fund that buys high-quality debt with short maturities. For example, the price of Vanguard Short-Term Investment-Grade (symbol VFSTX) should fall only 2% if interest rates rise one percentage point. In the meantime, you get a 1.7% yield.

For high income. The two categories that offer the best yields -- junk bonds and emerging-markets debt -- have seen big run-ups in prices (and accompanying declines in yields). It's hard to argue that either area is undervalued. If you want to put a small amount of your bond money into junk, consider T. Rowe Price High Yield (PRHYX). A consistent performer, it yields 6.4%. Likewise, don't go overboard on emerging-markets bonds. As the condition of developing nations continues to improve, rating agencies are likely to upgrade their assessments. But the bonds are still risky. A top choice is Fidelity New Markets Income (FNMIX), which yields 4.5%.

To diversify. You want a fair yield, but you don't care about short-term changes in principal as long as you don't suffer permanent losses. One idea is to build a ladder of Treasuries maturing in one, two, three, four and five years. Then add a diversified fund, such as Dodge & Cox Income (DODIX). It has an average maturity of seven years and a yield of 3.6%.

Slim Pickings in Bonds

With money funds paying nothing, you must take chances to get yield. Don't forget: They higher the yield, the bigger the risk. The following is a roundup of average yields, as of November 5, from different types of investments.

Average taxable money-market fund: 0.03%Ten-year Treasury bond: 2.5%Intermediate-maturity municipal bonds (interest exempt from federal income taxes): 2.7%Intermediate-maturity corporate bonds: 2.8%Emerging-markets bonds: 5.3%High-yield corporate bonds: 7.1%

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