Bonds can help diversify your portfolio, but they are not risk-free. You can learn to identify and evaluate the risks and see if they work to your advantage or disadvantage. Find out more about how bonds work and how to put them to work for you. 

Risk in the bond market 

Bonds have two major vulnerabilities — interest rate changes and the potential default of the issuer. Rating agencies can help you monitor the risk profile of a company and mitigate potential risk. Interest rate changes are a bit harder to guard against. Long-term investors will go through several cycles of interest rate hikes and cuts. That is a risk you can spread out by owning different investments with varying maturity dates.  

Rising interest rates

The market value of your bonds will decline when interest rates rise. This intractable relationship suggests that, as a bond investor, you should be aware of what steps you can take to reduce the looming risk. 

Don't buy bonds when interest rates are low or rising. Put your cash in a money-market fund or in certificates of deposit maturing in three-to-nine months. The ideal time to buy bonds is when interest rates have stabilized at a relatively high level or when they seem like they are about to head down. When interest rates drop below the coupon rate of your bond, the value of the bond increases. 

Stick to short- and intermediate-term issues. Maturities of three to five years will reduce the potential volatility of your bond holdings. They fluctuate less in price than longer-term issues, and they don't require you to tie up your money for ten or more years in exchange for a relatively small additional yield.

Acquire bonds with different maturity dates to diversify your bond holdings. A mix of issues maturing in one, three and five years will protect you from getting hurt by interest rate movements you can't control. Mutual funds are an excellent way to achieve diversity in your bond investments.

Issuer default

Interest-rate rises aren't the only potential enemy of bond investors. Another risk to consider is the chance that the organization that issued the bonds won't be able to pay them off. It's not realistic to expect that you could do the kind of balance-sheet analysis it takes to size up a company's ability to pay off its bonds in ten, 20 or even 30 years.

Importance of bond ratings and rating agencies 

Assessing the creditworthiness of companies and government agencies issuing bonds is a job for the pros, the best known of which are Standard & Poor's and Moody's. If the issuer earns one of the top four "investment grades" assigned by the companies — AAA, AA, A or BBB from Standard & Poor's, and Aaa, Aa, A or Baa from Moody's — the risk of default is considered slight. See Bond Basics: What the Ratings Mean for more details.

Ratings below investment grade indicate that the bonds are considered either "speculative" (BB, Ba or B) or in real danger of default (various levels of C and, in the S&P ratings, a D, indicating that the issue is actually in default). You can consider any issue rated speculative or lower to be a "junk" bond, although brokers and mutual funds usually call them "high-yield" issues.

Three important things to remember:

Use caution with junk bonds or high yield bonds. Individual junk bonds are very risky and it's best to avoid them unless you're willing to study the company's prospects closely. Alternatively, you could purchase shares in a junk bond mutual fund, which would ease the risk a bit through diversification. Even then, junk bonds should never occupy more than a sliver of your portfolio.

Check ratings. Check the rating of any bond that you are considering purchasing or already own. A broker can give you the rating, or you can check online sources, including S&P, Moody's and Bondsonline.com. For a mutual fund, the prospectus will describe the lowest rating acceptable to the fund's managers, and the annual reports should list the bonds in the fund's portfolio, along with their ratings. In general, the lower the rating, the higher the yield a bond must offer to compensate for the risk.

Diversify your portfolio. Diversify by buying bonds from several issuers or by investing in bond mutual funds. The fact that a municipal or corporate bond has a high rating is no guarantee that it is completely safe. 

All of the major credit-rating agencies missed the signs of distress at Enron Corporation, failing to lower their safety ratings until just days before the giant company filed for bankruptcy protection in late 2001. The raters said they had been deceived by Enron and would have dropped their ratings much sooner if they had had the facts. 

Bottom line

Generally, bonds are considered safer than stocks and used as a way to mitigate risk. But few investments come with zero risk and risk is relative. Why are you investing? When do you need the principal back? Consider these two questions when deciding the type of bond to buy and the maturity date(s) of the bonds. Gauging your risk tolerance and knowing the time horizon you are working against will give you two guideposts for deciding what should be your investment. 

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Bond ratings are an important market factor for every investor to understand. In short, bond ratings can help you decide whether to make an investment.

Knowing what bond ratings mean can help you diversify your portfolio in an efficient way and to manage your overall risk.

At the most basic level, bond ratings indicate the likelihood of repayment in accordance with the terms of the issuance. But competing bond rating systems can make it more complicated to understand what ratings mean.

Let's dig into the agencies and their respective bond ratings to better understand how to use them to evaluate the risks of your potential fixed-income investments.

The relationship between risk and yield

When you buy bonds, it's tempting to look for the highest available yields. But yield figures can be misleading.

You also need to consider the quality of the bond itself. If there's any doubt about the ability of the bond issuer to pay on time, high yield could be poor compensation for the risk.

In general, small investors should stick with high-quality bonds.

At the top of the safety scale are U.S. government bonds. The government is the only borrower in the market that can print money to pay its debts, if necessary.

Treasury bonds, notes and bills are backed by the full faith and credit of the government. They top the list of the safest financial assets you can buy.

Securities issued by U.S. agencies, corporations and local governmental units have a higher risk profile.

Here, you'll find bonds ranging in quality from those that are nearly as solid as U.S. government issues to those close to or already in default.

How do you find high-quality bonds? Reliable and respected ratings agencies gather all the data and issue bond ratings.

Financial professionals all over the world use bond ratings, which greatly impact bond prices and bond yields.

What are the main bond ratings agencies?

Most widely traded bonds are rated by at least one of the major agencies in the field — Moody's Investors Service and Standard & Poor's Corp.

Fitch also rates bond issues for default risk.

S&P Investment Grade Ratings: AAA, AA, A, BBB, BB, B

Moody's Investment Grade Ratings: Aaa, Aa, A, Baa

S&P Speculative Grade Ratings: BB, B, CCC, CC, D

Moody's Speculative Grade Ratings: Ba, B, Caa, Ca, C

Standard & Poor's AA, A, BBB, BB and B ratings are sometimes supplemented with a plus or a minus sign to raise or lower a bond's position within the group.

Moody's applies numerical modifiers in each generic rating classification from Aa through Caa.

The modifier 1 indicates that the obligation ranks in the higher end of its rating; a 2 indicates a midrange rank; and a 3 indicates a ranking in the lower end of the generic rating category.

The investment grades include bonds ordinarily bought by individuals and institutional investors seeking a steady stream of income and safety.

BBB/Baa are the lowest ratings that qualify for commercial bank investments.

It's a borderline group for which, in Standard & Poor's words, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for bonds in higher-rated categories.

Dipping below BBB/Baa takes you into speculative territory. Because of their higher risk of default, such bonds must pay higher yields.

"High yield" is the marketing name for what most people call junk bonds.

Moody's and Standard & Poor's don't always agree on a bond's rank. It's not unusual for them to rate an issue one grade apart.

If you see this happening, take it as a sign of uncertainty about the company that issued the bond.

How bond ratings affect price

Normally, you pay a higher price, and receive a lower yield, with each notch you move up the quality scale.

A triple-A bond usually costs more than a double-A with comparable characteristics, a double-A costs more than an A, and so on.

Few investment-grade issues have defaulted, but the few instances of default are enough to reinforce the attractiveness of the highest ratings.

The rating agencies try to track the financial condition of issuers and update their ratings if necessary.

Many issues are either upgraded or downgraded each year, so check current ratings when buying bonds that have been on the market for some time.

The bottom line on bond ratings

Bonds are often considered a safe way to park money, collect interest and cash in at maturity. That's true of investment-grade bonds, but not all bonds get that coveted rating.

Ratings agencies do a thorough analysis and grade bonds according to their risk, including likelihood of default.

Use their bond ratings as a guidepost and don't take on more risk that you can bear for the promise of a large return that might never materialize.

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Interest rates are rising and stock prices are falling, so investors naturally start thinking about bonds. But be careful.

Peter Lynch, the manager of Fidelity Magellan fund during its spectacular run in the 1980s, once said, "Gentlemen who prefer bonds don't know what they are missing."

Generally, I agree. Dow 36,000, the book I coauthored, made the case that, because history shows that stocks and bonds are equally risky over the long term and that stocks return an average of four to five percentage points more a year, the obvious choice is stocks.

But there are reasons to own bonds. First, in the short term, bonds fluctuate much less than stocks, and you may need a reliable investment because you have a large outlay coming up – a college tuition bill or a down payment on a house, for example.

Second, bonds provide ballast for a portfolio. According to research by Russell Investments, since 1997 the correlation between stock and bond returns has been mainly negative. In other words, when one goes up, the other tends to go down, and vice versa. As a result, you get a smoother ride. Finally, bonds supply reliable income – though recently not much.

Over the past decade, bonds have been especially unproductive investments. Since 2012, the annual yield on a Treasury bond that matures in 10 years has averaged just 2% per calendar year and has never exceeded 3%.

The Vanguard Intermediate Bond Index Admiral (VBILX), a popular mutual fund that owns both government and corporate bonds and charges expenses of just 0.07%, has returned an annual average of just 3.1% over the past 10 years, including interest payments and gains and losses from selling assets. (Nonetheless, I'm a fan of this fund for the long term.)

Lately, rates have perked up. Moody's Seasoned Aaa Corporate Bond yield for the safest debt jumped from 2.5% on Dec. 3 to 3.3% on March 3. That's still only about half the average of the past 40 years.

What Are Bonds?

A bond is an IOU, a promise by a business or government to repay an investor for a loan – typically on a specific date (maturity) and at a specific interest rate (coupon, or yield).

Bonds are actively traded, so a 10-year, $10,000 bond issued with a coupon of 3% might trade a few years later at $7,000. Why? First, the borrower might get into financial trouble, and investors doubt they will be repaid. This kind of credit risk applies mainly to corporations or state, local or foreign governments – not, so far, to the U.S. Treasury. Second, interest rates may rise after you buy your bond, so new, similar bonds are issued at higher coupons. Higher rates make your old bond less attractive, so its price on the market falls.

If you hold your bond to maturity, the lower price in the interim won't matter; you'll get the bond's full face value when it comes due. But if you have to sell sooner, you'll take a loss.

Bonds present one other kind of risk: Inflation diminishes the value of the dollar, so that even when you get your $10,000 at maturity, it will have the purchasing power of, say, $6,000. Some decline in value is inevitable, and that expectation is built into the bond's yield, but inflation may be worse than the market anticipates.

Right now, long-term inflation expectations are extremely low, even though the consumer price index (CPI) soared 7.9% in the 12 months that ended Feb. 28. The St. Louis Federal Reserve Bank extrapolates from TIPS, or Treasury inflation-protected securities, that the annual increase in CPI over the next 10 years will be about 2.7%.

My view is that intermediate (five- to 10-year) rates will probably rise another two or three points in the next few years, making bond yields much more attractive.

How Do I Invest in Bonds?

The choices are vast, but, for many investors, buying individual bonds at the riskier end of the debt spectrum – high-yield or junk debt, for example, or bonds issued by shaky governments – is just too adventuresome. Unless you spend a lifetime examining the nuances of particular bond issues, you will probably get better returns at much the same risk with stocks. I am not fond of individual municipal bonds, either. Yes, interest is exempt from federal taxes, but munis, accordingly, have lower yields.

Buying individual government bonds through a broker or directly from the U.S. Treasury is a reasonable option. But owning a bond, or even several, locks you into today’s rates or forces you to take a loss if rates rise.

The best alternative is a mutual fund, whose assets evolve. For instance, if a bond fund has an average maturity of five years, about one-fifth of its holdings will come due in any 12-month period. The fund manager (or the computer algorithm, in the case of index funds) will then decide to buy new bonds with the cash from its maturing bonds, and, if rates are rising, those bonds will have higher yields.

And a fund manager can shift to higher yields by deploying cash from new investors, who tend to flock to bond funds as rates rise. Some of the best funds leaven their safer holdings with riskier debt to boost yields.

When looking at specific funds, decide how much volatility you can tolerate by checking out the duration, a figure expressed in years that indicates the sensitivity of a fund's portfolio to interest rate increases. For example, the Fidelity Long-Term Treasury Bond Index (FNBGX) has a duration of over 18 years, which means if rates rise 1%, the fund's value will fall about 18%. That's risky. (The value, of course, will shoot up if rates fall.)

Although I have been impressed over the years with many active bond fund managers, the expenses they charge can eat up returns when yields are low. For example, one of the largest funds, the Pimco Total Return (PTTAX), which owns a mix of high-quality government and corporate bonds, charges 0.8% and has had an average annual return over the past five years of 3.0%. In the same asset category, I like the Fidelity Investment Grade Bond (FBNDX) better. Expenses are 0.45% for a fund whose average annual return for the past five years is 3.6%.

By contrast, the Vanguard Long-Term Corporate Bond (VCLT), an exchange-traded fund based on an index, has an expense ratio of just 0.04%. It's an excellent fund if you are willing to accept more risk. Holdings are investment grade, but just barely, with 88% of assets rated A or BBB. And the fund has a duration of more than 14, so it's sensitive to rate swings. But more risk, more reward: The fund has returned an annual average of 5.4% over the past five years.

Also recommended is the T. Rowe Price Total Return (PTTFX), which has about one-fourth of its assets rated below investment grade. With an expense ratio of 0.46%, the mutual fund has returned a five-year average of 4.0%. Its bonds mature in an average of eight years, so if rates rise, the portfolio's yield will rise, too.

Another way to protect against rising interest rates is the SPDR Bloomberg Barclays 1-10 Year TIPS (TIPX), an ETF with expenses of 0.15%. TIPS become more valuable as inflation and interest rates increase. Technically, TIPS can have negative yields, as some do now, but the income from the bond gets enhanced when inflation rises by adjustments to the principal.

If rates do rise, returns may soon reach the 5% range for many bond funds. But higher rates, remember, also have the effect of depressing economic growth, which in turn can force borrowers into default. Bond investing is always a matter of balance: long versus short maturities; risky versus safer credits. No more so than now.

James K. Glassman chairs Glassman Advisory, a public-affairs consulting firm. He does not write about his clients. He owns none of the securities mentioned. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence. You can reach him at James_Glassman@kiplinger.com.

The environmental, social and governance (ESG) rating firm MSCI downgraded Russia’s ESG Government rating this week, from B to the lowest rating possible, CCC.

Many ESG fund managers rely on MSCI ratings for portfolio construction and for ETF indexes. Thus, many Russian companies could end up being cycled out of funds that rely on maintaining a minimum ESG ratings bar for inclusion.

The downgrade acts as yet another hit to Russian investments, many of which have been flattened since the country’s invasion of Ukraine. It's not the first one, either; MSCI ESG Research originally downgraded Russia at the end of February.

“Since the downgrade to B on Feb. 28, we have observed further heightening of Russia’s ‘Economic Environment’ and ‘Financial Governance’ risks based on the widening domestic impact of international sanctions and financial isolation on Russia’s economy,” the MSCI notice said.

Many firms have halted new investments in Russia. JPMorgan Chase, BlackRock and State Street have all announced that they are exiting Russia as able, and JPMorgan also removed Russian debt from its tracking indexes.

You can thank an increasingly untenable financial situation for both the country and its investments alike. Debt rating agencies S&P, Fitch and Moody’s lowered Russia’s credit rating to at or near junk status as of March 3, a full five days before MSCI made its latest downgrade.

ESG was at least part of the conversation. These debt rating agencies incorporate environmental, social and governance considerations when they are believed to be “material,” or important to a company’s financial performance.

Fitch, for example, cited its incorporation of country-level World Bank Governance Indicators for political risk and rights in its credit assessment. Moody’s considers a country’s inability to repay debt an ESG criterion, also pointing to Russia’s poor governance and corruption.

ESG Not Exactly Hot on Russia in the First Place

A Bloomberg analysis found that only about 300 of 4,800 ESG funds held Russian companies. Bloomberg noted that several ESG funds invested in Russia in search of green or responsible companies to meet intense demand from investors. These ESG investors might have waived human-rights concerns to further goals like renewable energy.

Other ESG investors, Bloomberg noted, steered clear of Russia.

Morningstar’s Jon Hale found that ESG funds held fewer Russian companies than conventional funds.

“Sustainable emerging-markets equity funds have, on average, just 1.8% exposure to Russian equities, nearly two-thirds less than the overall category average.” Hale notes that in most cases, Russian companies are ESG laggards and don’t meet fund criteria.

The question going forward is whether future ESG criteria will take a longer, harder look at investments in autocracies.

Often retirees will have excess funds sitting in the bank. Far more than they need for an emergency. And in some extreme cases, they have all their money in the bank because they don't feel comfortable putting it in stock-related portfolios.

The result is that they may spend their golden years struggling to have enough income to live a comfortable lifestyle.

One possible solution — especially for retirees in the middle tax brackets — is to consider higher-quality, shorter-term tax-free bond funds. This way, instead of renewing what are often one- or two-year CDs every year for the rest of their life, they may be able to get a much better after-tax income.

How Risky Are Municipal Bonds?

Municipal bonds — or munis for short — provide a way that states or municipalities can borrow the funds they need to finance a public works project, and the interest they pay to investors who buy into them is exempt from federal taxes. Owners may owe a little in state taxes if the fund owns bonds issued outside their home state, but the same state income tax is always owed on the CD interest, so this would not eliminate the munis’ advantage over CDs.

The first thing to understand about tax-free municipal bonds is that unlike the money in the bank, they fluctuate and tend to move in the opposite direction of interest rates. Also, they are not FDIC insured.

How Can You Reduce That Risk?

However, there are strategies to reduce the overall risk enough so that some retirees may feel comfortable with them, and end up likely enjoying higher income. The way to reduce fluctuation in a municipal bond fund is to make sure that the average maturity of the bonds inside the fund is reasonably short. For example, Vanguard Intermediate Term Tax Exempt Fund Admiral (VWIUX) has an effective maturity of 5.3 years. Such short maturities tend to keep the fluctuation of the share price of the bond fund very modest most of the time.

To illustrate, if we go back the last 10 years this fund had one negative year, where it was down less than 1.5%. All the other years it had a positive return and a 10-year average annual total return of 3.88%. And, unlike with CDs, the interest it generated was tax free. Also, while the fund itself does not have a specific maturity date, the mutual fund shares are liquid, so the retiree can sell them on any business day at the fair market value.

To address the default risk (the risk that the state or municipality fails to pay on schedule), make sure you buy a fund where you are diversified over several hundred bonds being selected and watched by an experienced money manager. Also, be sure that the average credit quality of the bonds in the fund is AAA, AA, and A by Standard & Poor’s or Moody’s, since this means they will have an extremely low chance of default.

This same Vanguard fund mentioned above has over 9,000 bonds in it, so even if one defaulted, on average it would represent a minuscule part of the retiree’s money. And over 90% of these bonds are AAA, AA, or A rated.

How Do Tax-Free Muni Returns Compare to Taxable CDs?

The big plus of a shorter-term tax-free municipal bond fund is as an alternative to a retiree looking for higher income than a bank CD, but with less risk than being in something as risky as stocks.

To illustrate let’s assume a retiree has been buying shorter-term CDs averaging 1.5% and renewing them every year or two over the last several years. This would mean for every $100,000 sitting in the bank, they're averaging $1,500 in taxable interest per year. If the retiree is in a 24% tax bracket, he or she will give up 24% of this $1,500 in federal taxes, which would be $360, leaving the investor with $1,140 in after-tax interest.

Compare this to taking the same $100,000 and putting it in a short-term, high-quality tax-free bond fund like the Vanguard Intermediate Term Tax Exempt Fund mentioned above, which recently had a yield of 2.7%.

This means on $100,000 the investor would make $2,700 and it’s all federal tax-free. On an after-tax basis instead of earning $1,140, the retiree earned $2,700 picking up an extra $1,560.

While all the pros and cons should be weighed, including the risk, for retirees with a slightly higher risk tolerance, this may be a way to pick up more retirement income.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

I recently met with a woman who came to me for advice on her existing portfolio. She had been investing for a while but was concerned her portfolio would not weather another market downturn. As she was close to retirement, she wanted to be reassured that her investments were allocated conservatively.

One of the first things she mentioned was that she did not like junk bonds and would not have them in her portfolio. As I scanned her list of investments, I was shocked to discover that she had not only one high-yield bond fund but three! Such is the nature of junk bond funds: They can be very hard to spot.

High-yield bond funds are typically marketed to individual investors using pleasant-sounding names to suggest that they are less risky than they truly are. But, don’t lose sight of the fact that “high yield” is a euphemism for “junk.”

Funds with names like Opportunity & Income or Income Advantage are intended to inspire confidence even though the language in the prospectus may state that, “junk bonds … involve greater risk of default.”

With Greater Reward Comes Greater Risk

According to Bloomberg, January 2019 was the best month for high-yield bond sales since at least September 2018. The funds that bought those bonds also had a great month, making up most of the losses they sustained last year. It appears that investor appetite for high-yield bond funds is still strong. But, do those funds make sense in a diversified portfolio?

Junk bonds are the corporate debt equivalent of a subprime mortgage, because they are regarded as less than “investment grade” by debt rating agencies like Standard & Poor’s and Moody’s. Companies that have weak balance sheets, pay their bills slowly or have defaulted on past obligations would be the worst examples of junk bond issuers. Companies whose businesses are highly cyclical, very capital intensive or have low profit margins are more typical issuers of “high-yield” debt.

Because of the greater risk of default, investors require companies that sell junk bonds to pay higher interest rates than more stable companies. Interest rates on junk bonds are determined in much the same way as interest rates on consumer loans. The lower a person’s credit score; the higher the interest rate they’ll pay on their debt. It’s the same with corporate borrowers. In each case, the lender needs to be compensated for taking additional risk. And, that’s the whole point here. Investors who own junk bond funds accept additional risk that isn’t present in higher quality fixed income products.

Junk Bond Risk in The Context of Return

All investments involve risk, but investors can reduce it by diversifying their holdings across various asset classes (i.e., employing strategic asset allocation). The factors that go into the asset allocation decision are unique to the specific individual investor. But, in the end, the portfolio that emerges should provide that investor with the highest expected return with the lowest possible amount of risk. Interestingly, the theory advancing that approach is based on a portfolio that includes just government bonds, which are typically classified as a risk-free asset.

If a portfolio is designed to achieve specific future outcomes, built based on the tenets of generally accepted investment best practices, and if doing so can provide the expected return necessary to achieve those outcomes, then why would that same investor purposefully inject more risk into the mix than is necessary?

Junk Bond Risk in The Context of Treasuries

Right now the spread (difference) between junk bond yields and yields on U.S. Treasury Bonds is about 4 percentage points. That’s a pretty big differential in today’s interest rate environment. But, consider that spread in the context of the risk that junk bonds have over government bonds.

Treasury Bonds are backed by the full faith and credit of the United States of America. The default risk on them is as close to zero as exists. That can’t be said of any issuers of junk bonds.

All investments come with risk. Even Treasuries have inflation risk and interest rate risk. But both of those risks can be mitigated using portfolio management techniques like laddering. That might be a little harder to do with junk bond funds, especially if fund flows remain as negative in 2019 as existed in 2018. Sharp outflows can affect redemptions and pricing of funds and EFTs. Those risks are completely absent from Treasuries.

Consider the possibility that the U.S. economy may at some point in the future experience a slowdown or recession. Neither of those circumstances is likely to have an effect on the ability of the federal government to pay its obligations to bondholders. Obviously, the same cannot be said of junk bond issuers.

What This Means, and What Investors Should Be Doing

For investors seeking to generate income and reduce portfolio volatility, bonds are a perfect fit. But, stretching for yield using less than investment grade bond funds might not be the most prudent way to achieve those objectives.

Practically speaking, how can an individual investor determine what bonds they have and if they are appropriate? As a first step, research the funds and ETFs you own. Many websites (Yahoo Finance, for example) will provide information on the underlying holdings and the quality of the bonds in the fund you own. Remember, quality bonds or investment grade bonds have A ratings or above. If the majority of the bonds in the fund are rated B or lower, it’s a junk bond fund. Also, check the yield. If it is 4 percentage points or higher than a Treasury bond, it’s probably a junk bond.

In addition, look for the term “high yield” in the fund’s literature. You generally won’t see fund companies using the term “junk bond” or advertising the higher risk factor. High yield sounds like a desirable trait. Unfortunately, many investors don’t realize that a high-yield bond fund holds risky positions, and those higher yields can add extra volatility. If your goal is to add stability to your investments, you would be better advised to focus first on quality.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Dividend safety is a core element of conservative income investing and selecting dividend stocks. Not only does a payout cut reduce a portfolio’s income stream, but it can also significantly hurt a nest egg’s long-term returns.

Companies that cut or eliminated their dividends recorded an annual loss of 0.4% per year from 1972 through 2016 while being much more volatile than the broader market, according to data from Ned Davis Research.

No one wants to outlive their retirement savings, so seeking out safe dividend stocks clearly is an important capital preservation strategy.

Income-hungry investors tend to be drawn to stocks with higher yields. However, exercising caution to avoid companies with the greatest risk of reducing their dividends in the future is just as important.

The following nine dividend stocks appear to be high-quality businesses with safe and growing yields above 5%. Here’s a closer look.

Data is as of March 22, 2018. Dividend yields are calculated by annualizing the most recent quarterly payout and dividing by the share price. Click on ticker-symbol links in each slide for current share prices and more.

• Market value: $6.6 billion
• Dividend yield: 6.6%

Diversified sources of cash flow can help improve the safety of a company’s dividend, and W.P. Carey (WPC, $61.18) really delivers on this front.

The real estate investment trust runs a balanced business with industrial-focused properties accounting for 30% of its portfolio, followed by office buildings (25%), retail (17%), warehouses (14%) and self-storage (5%). About a third of the business is outside of the U.S., and its top 10 tenants – which include German retailer Hellweg, U-Haul and Marriott (MAR) – account for just 32% of total rent.

Management has also focused the business on high quality properties, as demonstrated by W.P. Carey’s 99.8% occupancy rate. With a weighted average lease term near 10 years and 99% of its leases containing contractual rent escalations, cash flow is very predictable and somewhat insulated from an inflationary environment.

All of these factors, combined with the company’s investment-grade credit ratings from Standard & Poor's and Moody’s, have enabled management to reliably raise the dividend each year since WPC went public in 1998.

Analysts expect W.P. Carey’s adjusted funds from operations (AFFO) per share to rise around 1% over the next year, which would put its AFFO payout ratio at a conservative level of 75%. In other words, its dividend should remain on very solid ground for the foreseeable future.

• Market value: $2.2 billion
• Dividend yield: 6.1%
• Main Street Capital (MAIN, $37.28) is a monthly dividend stock that serves an essential role in the U.S. economy by providing capital to mid-sized private businesses. These companies use the debt or equity funding provided by Main Street for leveraged buyout deals, acquisitions, recapitalizations and growth initiatives.

Despite the inherent risks in the lending business, Main Street’s conservatism can be seen in its investment-grade credit rating, and ability to continue paying regular dividends (it switched from quarterly to monthly in 2008) without interruption for more than a decade, including during the financial crisis.

Management also has made sure to keep a diversified investment portfolio to reduce risk, with no industry representing more than 7% of the portfolio’s value, and the largest portfolio company accounting for just 4.6% of total investment income.

Besides its portfolio diversification, Main Street’s payout safety benefits from the firm’s efficient internally managed operating structure. Specifically, the company’s ratio of operating expenses to total assets sits near 1.5%, which is about half of the industry’s average.

Lower costs improve profitability and allow the company to pursue more conservative loans, which bodes well for the dividend’s security if and when the next recession hits.

MORE FROM SIMPLY SAFE DIVIDENDS: Warren Buffett’s Dividend Portfolio

• Market value: $229.1 billion
• Dividend yield: 5.6%
• AT&T (T, $35.37) is an absolute giant in the telecom and media industries and generated more than $160 billion in revenue last year. With more than 155 million wireless customers in North America, 47 million pay TV connections and 16 million internet subscribers, AT&T derives meaningful advantages from its size.

Morningstar senior equity analyst Allan C. Nichols believes AT&T has somewhat of a moat because of “the cost advantage and efficient scale of its wireless business and the cost advantage of its wired businesses. These advantages should enable the firm to generate excess returns on capital, more likely than not, over the next decade.”

The company’s economies of scale have allowed it to consistently generate positive free cash flow each year for more than a decade while paying higher dividends annually for 34 straight years.

Competition is fierce in many of the company’s markets, and AT&T has taken on significant debt to acquire businesses outside of its core the wireless operations. There is also some strategic uncertainty as the Time Warner (TWX) deal remains in regulatory limbo and the pay TV market evolves quickly with the continued rise of over-the-top services.

Despite these challenges, AT&T’s dividend appears to remain solid. The company’s adjusted earnings payout ratio is projected to dip below 60% over the next year, reaching its lowest level since 2008.

Even if the Time Warner deal closes, resulting in an ever-higher debt load and meaningful new share issuance, Simply Safe Dividends estimates that AT&T’s free cash flow ratio would likely sit between 70% and 80%. In other words, while future payout growth may be muted as AT&T pays down debt in the years ahead, the stock’s high current yield still should be safe.

• Market value: $14.2 billion
• Dividend yield: 5.1%

Known as “The Monthly Dividend Company,” Realty Income (O, $49.87) is a high-quality real estate investment trust that has paid uninterrupted dividends for nearly 50 years.

The company owns more than 5,000 commercial properties that are diversified nicely by industry (none greater than 10.6% of rent), tenant (the largest is 6.5% of rent) and geography (the largest state exposure is under 10% of rental revenue).

Importantly, management has focused on quality within each of those buckets. For example, half of the company’s 20 largest tenants have investment-grade credit ratings. Realty’s four largest industries (drug stores, convenience stores, dollar stores, health and fitness) also are largely resistant to the rise of e-commerce.

Morningstar equity analyst Brad Schwer recently commented that “Realty Income remains well positioned in the current retail environment. Over 90% of its revenue comes from tenants with non-discretionary, service-oriented, or low-price components of their businesses.”

Realty Income’s high yield should remain safe for the foreseeable future, and management even recently announced the company’s 96th monthly dividend increase.

• Market value: $229.1 billion
• Dividend yield: 5.6%
• Tanger Factory Outlet Centers (SKT, $21.77) has a portfolio of 44 upscale outlet centers that lease more than 15 million square feet of space to nearly 500 brand-name retail companies that operate more than 3,100 stores.

While the retail environment is notoriously competitive and difficult to thrive in over the long term due to fickle consumer tastes, Tanger has been a clear success story.

Impressively, the business has increased its dividend each year since going public in 1993. Management’s focus on differentiated properties, quality tenants with in-demand products, and financial conservatism have helped.

CFRA equity analyst Chris Kuiper, CFA expects “relatively stable demand for Tanger’s space as the outlet venue will remain a differentiator for retailers that continue to face pressure in traditional stores and malls.” However, he also noted that Tanger expects same-store net operating income to be flat to down 1% in 2018, so little dividend growth is likely until the environment improves.

With no plans to build new shopping centers this year, Tanger is generating substantial cash flow that is expected to bring its AFFO payout ratio below 70%, according to Simply Safe Dividends. So while brick-and-mortar retail has its challenges, but Tanger appears to be one of the financially healthiest and most conservative companies in the space for safety-seeking income investors to consider.

MORE FROM SIMPLY SAFE DIVIDENDS: A Guide to Investing in REITs

• Market value: $44.2 billion
• Dividend yield: 5.3%
• Southern Company’s (SO, $43.81) last few years have been a relatively wild ride for a regulated utility. Several multibillion-dollar construction projects have blown through their initial budgets and faced delays, creating a good deal of regulatory uncertainty and financial constrain.

So why is Southern Company on this list of safe, high-yielding dividend stocks to consider?

Simply put, the worst seems to be behind the company, improving Southern’s dividend safety and long-term growth outlook.

Specifically, in December 2017, Georgia regulators approved Southern’s proposal to continue the construction of its nuclear reactors, as well as its updated cost and delivery schedule.

Morningstar analyst Charles Fishman, CFA, commented in February that the firm is “confident that the company can get back to its 4%-6% long-term EPS growth target. We believe the company can exceed 6% growth in the next decade if the new nuclear units at Vogtle come in on schedule and on budget.” Fishman noted that the project is eight months ahead of the revised schedule that regulators approved, so the outlook could indeed finally be brightening.

Project issues aside, Southern Company has paid uninterrupted dividends since 1948, driven largely by the predictable nature of its earnings, almost all of which are generated from regulated activities.

As management (finally) delivers on the nuclear projects that have weighed on the firm in recent years, SO should continue offering income investors a nice blend of generous yield and moderate payout growth.

• Market value: $9.0 billion
• Dividend yield: 7.2%
• Iron Mountain (IRM, $31.64) converted to a real estate investment trust in 2014 and serves the information storage, management and data center needs of more than 225,000 customers in a wide range of industries.

The physical storage business has proven to be a reliable cash cow over the years. in fact, IRM notes that half of the boxes stored in its facilities 15 years ago still remain there today.

While it’s true that the world is becoming more digital by the day, physical storage needs continue growing. Iron Mountain has seen its worldwide box volume increase in each of the past five years, for example. However, Iron Mountain is not resting on its laurels. The company plans to shift more of its revenue mix to developing markets, data centers and other adjacent businesses over the next several years and beyond.

As the company’s profitable growth plans play out, management expects leverage to decline and the payout ratio to become even safer.

Conservative income investors will also be pleased to hear that the minimum dividend per share is forecast to rise from $2.35 in 2018 to at least $2.54 in 2020, providing a little growth to go along with the high yield.

• Market value: $4.8 billion
• Dividend yield: 4.9%
• STORE Capital (STOR, $24.46) recently dropped just below the 5% level, but has been trading either just above or just below a 5% yield for most of the past year. This REIT popped up on many dividend investors’ radars when news surfaced that Warren Buffett’s firm Berkshire Hathaway (BRK.B) had purchased approximately 10% of its shares in 2017.

STORE owns a well-diversified portfolio consisting of nearly 2,000 properties leased by approximately 400 customers including the likes of AMC Entertainment (AMC), Applebee's and Bass Pro Shops. Its business model generates predictable cash flow thanks to its average remaining lease term of 14 years and 99.6% occupancy rate.

Even better, roughly two-thirds of STORE’s assets are service-focused properties, including movie theaters, fitness clubs and early childhood education centers. As a result, the rise of digital shopping is less of a concern.

Warren Buffett likes to buy well-managed companies with a long runway for growth, and STORE Capital delivers in this area as well.

Management estimates that its target property market exceeds $3.3 trillion in value and includes more than 1.9 million locations (nearly 1,000 times more than the company owns today).

With Berkshire Hathaway providing a vote of confidence in the business, STORE Capital should have plenty of ability to continue pursuing profitable property acquisitions while growing its dividend along the way.

• Market value: $53.0
• Distribution yield: 6.8%*
• Enterprise Products Partners L.P. (EPD, $24.46) is one of the highest quality firms in the space and was quick to issue a press release stating it expected no material impact to its financial results from the news.

Many master limited partnerships (MLPs) were hit hard in mid-March when the Federal Energy Regulatory Commission revised its 2005 tax policy to disallow interstate pipelines owned by MLPs to recover a tax allowance in the rates they charge customers.

The partnership owns a network of storage and processing facilities, as well as 50,000 miles of pipelines that help move natural gas, oil and various energy products across the country. Its transportation network connects to every U.S. major shale basin and should benefit over time as domestic energy production continues rising (thanks largely to low-cost fracking technologies).

While some MLPs have stretched their financial limits for the sake of growth, Enterprise Products Partners L.P. has taken a much more disciplined approach. In fact, management is retaining more internally generated cash flow with a goal to have the company self-fund the equity portion of its growth capital beginning in 2019. Doing this will reduce EPD’s dependence on fickle investor sentiment.

The company also enjoys an investment-grade credit rating and maintains an average distribution coverage ratio of 1.2. This financial conservatism has enabled Enterprise to grow its distribution for 54 consecutive quarters.

The outlook for payout growth remains firm. Argus analyst Bill Selesky is optimistic about the projects Enterprise is rolling out over the coming years. He expects “these projects and existing assets to support distribution growth of 5%-6% over the next 18-24 months.”

*Master limited partnerships pay distributions, which are similar to dividends, but are treated as tax-deferred returns of capital and require different paperwork come tax time.

Brian Bollinger was long T and WPC as of this writing.

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Pension decisions aren’t clear-cut, and they can have serious consequences for you and your family.

Take some clients of mine, for example. The husband, age 65, wanted the highest monthly payout he could get, so he chose a 100% single life option of $2,100 per month. With that type of payout, the payments would end when he died. The joint life option he could have chosen would have paid only $1,800 per month. But although the payments were lower, his wife would have received the same amount once he passed away (and keep her quality of life).

A year and a half later, he was diagnosed with terminal cancer.

If you’re contemplating retirement, it’s in your best interest to be proactive and research the different benefit payout scenarios available to you. According to the Employee Benefit Research Institute, only 2% of employees participate in a pension as of 2014 (compared to 28% in 1979). If you’re one of the fortunate, you could receive a stable, consistent amount of income per month for your entire life as well as a spouse’s.

On the other hand, several employers offer a lump sum option instead of lifetime payments, which might be a wiser option for some retirees (more on that in a bit).

Some people choose to take a lump sum and roll it into an IRA, managing the investments on their own terms. Others may take a lump sum and use it to buy an annuity held within an IRA. They receive a lifetime of guaranteed payments, similar to the lifetime payments that a pension could offer, but with more flexibility and control since you can choose from a plethora of companies. Of course, before going that route, you’d want to compare how much lifetime income the annuity you could buy from an insurer would compare to the lifetime income from your employer's pension.

4 Areas to Consider When Making Your Choice

To determine which path to take — whether you opt to take a lump sum and invest it yourself in an IRA or decide to take lifetime payments, either through your employer’s pension or by taking a lump sum and buying your own annuity instead — here are a few considerations to guide you:

• What is the overall financial strength of the company providing you guarantees? Annuities and bonds are rated through large credit-rating agencies, such as Standard & Poor's, Moody's, and Fitch Group. Ratings range from “AAA” (highest grade) all the way to “C” or “D” (considered junk). Weigh the ratings for the company your pension plan uses against those of the companies available to you on the open market if you were to take a lump sum and buy an annuity on your own.
• What is your health (and your spouse’s health) currently?
• How does the option you’re considering help your spouse or other heirs? For annuities and pension lifetime payouts, for example, typically, you'll get higher payouts with a life-only option. However, your payments would stop when you die, and your spouse would get nothing. Your payments would be lower if you opt to have them continue for your spouse, but spousal payouts are important for many married couples.
• What are the potential tax implications (e.g., will your Social Security benefits become taxable?) with a guaranteed income stream?

Lump sum considerations

There are several reasons why people might opt for a lump sum. If you can foresee a shorter retirement due to illness, it may suit you to manage a lump sum on your own, vs. taking a guaranteed lifetime income over a diminished lifespan. If you’re not married, then you should consider an IRA instead of a pension since there is more flexibility to pass the remainder to another family member or a charity.

In addition, if you’re confident in your nest egg and just want more control, a lump sum could be for you. For example, I have a 62-year-old client who is single and well-prepared for retirement. His benefit statement shows that at age 65 he could get a $1,200-per-month benefit, or he could take a lump sum of about $165,000. He is choosing the lump sum, because although the lifetime payout amount could be significantly higher over time, he doesn’t need the income and would rather have more flexibility and manage when he takes withdrawals.

On the other hand, a lump sum transfer to an IRA most likely will come with market risks, depending on what you do with it and who you choose to manage it. Considering the recent stock market fluctuations, managing a portfolio might not be a great idea. Not to mention that choosing this option can jeopardize a spouse’s lifetime benefit in comparison to other plan options.

Thoughts on annuities

If your main concern is a reliable income stream, then you may be better suited for the lifetime payments, whether from your company’s pension plan or by taking a lump sum and buying your own annuity. Certain annuities (e.g., fixed, fixed-indexed and immediate annuities) give retirees the opportunity to relax and not stress over daily market instabilities, and benefits can pass to a chosen spouse or heir. The main concern is their ability to keep pace with inflation.

Here’s how one client of mine came to his decision to buy an annuity. This man, who is married, has a pension through his employer with a single life option of $1,560 per month, a joint life option of $1,236 per month and a lump sum option of $250,000. His objective is to not only pass the same monthly benefit to his wife but potentially leave a remainder benefit to either his children or grandchildren. By transferring the $250,000 lump sum to an IRA and purchasing his own annuity, it will provide $1,004 per month ($232 per month less than his employer’s pension), but after he and his wife both pass away, their children or grandchildren will receive the remainder of their accumulated value. This scenario provides flexibility and possibly a benefit for their heirs.

As you can see, there are many moving parts to consider, and sometimes getting creative by involving other financial vehicles, such as life insurance, can increase your options or avoid future problems. For example, if couples want to go with a 100% single life option, they also could purchase a life insurance policy for the difference. Had my client who later discovered he had terminal cancer opted for this, his wife would’ve received a $150,000 death benefit.

In conclusion

So, the bottom line is that a suitable candidate for a lump sum would be someone who has all their income needs met for retirement and who wants to effectively plan for lower taxes in the future. On the other hand, a likely candidate to take the lifetime payments of a pension would be someone who will need the income to supplement Social Security or who anticipates the lifetime payout being higher vs. transferring and self-managing it.

The advice from a competent financial adviser will help you properly assess if a lump sum option is the right fit. Don’t forget to evaluate your goals, health, heirs, tax consequences and the plan for the unexpected.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

An Individual Retirement Account (IRA) is a tax-advantaged home for your retirement investments. Spared annual interruptions by the IRS to collect taxes on your earnings, your nest egg can grow faster than in a taxable brokerage account. Another potential benefit is that when you start drawing from your IRA years down the road, your tax bracket may be lower than when you were stocking your money away.

However, not everything belongs in an IRA.

The types of investments that work best offer periodic cash flows, whether it is in the form of interest payments, dividends or even capital gains, realized or unrealized. It all points to why investors open an IRA in the first place: to build wealth for retirement, not to speculate.

Read on to learn more about a few investments that belong in an IRA, and a couple that don’t.

Bonds essentially are loans made by an investor to a country, corporation or other entity. They make regular interest payments and return the principal value at the end of the loan’s term (maturity).

“High-yield” or “junk” bonds are an excellent type of bond to hold in an IRA. These are debt issues that have received credit ratings below investment-grade, which can reflect short-term risk or serious long-term financial trouble within a company or sovereign state.

Some non-investment-grade bonds*, while considered riskier than investment-grade bonds, still are likely to pay their interest and return principal. They tend to yield more to entice investors to take on that added risk. Investors can de-risk somewhat by purchasing high-yield bond funds, which hold numerous debt issues, providing diversification and protection against single defaults.

Income from most bonds and bond funds (junk or not) are taxed at ordinary income tax rates at the federal level, and sometimes the state level. However, investors who hold bonds in an IRA avoid taxes on this interest until they start to withdraw, which means they can reinvest the income for years and enjoy higher rates of compound growth.

* Ratings for less speculative non-investment-grade bonds are “BB+, BB and BB-” (Standard & Poor’s, Fitch) or “Ba1, Ba2 and Ba3” (Moody’s). Bonds rated lower than that may not be appropriate for retirement plans.

Municipal bonds, also known as “munis,” are debt obligations issued by state and local governments, and they inherently enjoy a few tax benefits. While capital gains from munis are subjected to federal, state and local taxes, interest payments usually are exempt from federal taxes. State and local authorities also exempt them from taxation, though usually only to investors living in the state in which the bonds were issued.

There is no restriction against putting municipal bonds in an IRA. However, munis typically offer lower interest rates than bonds of similar maturities because of their tax advantages. Putting them in an IRA adds little if no extra tax benefit.

Martin Walcoe, Executive Vice President of Sales Development at David Lerner Associates, points out one exception: Some municipal bonds are subject to the alternative minimum tax because they are issued to finance a project or activity that does not provide a major benefit to the public (say, a local sports facility). Because they may offer higher interest rates than traditional munis, Walcoe said investors sometimes put these bonds in tax-advantaged retirement accounts to avoid that levy.

Equities, or stocks, represent fractional ownership in a company. Investors hope to either participate in the growth of the business, collect income payments – called dividends – at regular intervals throughout the year, or both.

Any long-term retirement plan typically will hold both types of stocks, and both investments can take advantage of an IRA’s deferred taxation.

Some critics recommend against holding stocks in IRAs. Why? Because most dividends they pay and capital gains they produce get favored treatment when earned in taxable accounts. A long-term gain realized in a taxable account, for example, can be taxed as low as 0% and no higher than 23.8%. If earned in an IRA, there’s no tax as long as the money remains in the account. But all withdrawals are taxed at ordinary tax rates as high as 39.6%. Those who oppose investing in stocks inside IRAs point out the wide discrepancy in rates.

But, because long-term investing for retirement relies heavily on stocks — due to their historic superior performance over bonds or cash as well as for diversification — stocks do belong in your IRA.

Annuities have the same IRA problem as muni bonds: They’re already tax-favored investments. Tucking them inside the IRA tax shelter gives you no extra protection from the IRS.

Annuities are insurance products that grow at either a guaranteed rate or according to the performance of mutual-fund-like investments you choose. But whether inside or outside an IRA, the earnings grow tax-deferred. The taxman doesn’t get a crack at the earnings until you withdraw the money.

There are two ways to hold real estate in an IRA, one with more advantages than the other:

• REITs: Real estate investment trusts (REITs) are publicly traded entities that allow people to invest in real estate via the stock market. These companies typically own and/or operate real estate, but sometimes invest in real estate “paper” such as mortgage-backed securities. REIT dividends often are higher than many standard equities’ payouts, and adding REITs to your IRA can provide important diversification.
• Physical real estate: You can directly invest in real estate via an IRA, but not every IRA custodian allows this type of investment. You must find a custodian that provides self-directed IRAs, which allows more types of investments (including real estate) than other IRAs. Just be warned: Holding real estate with an IRA comes with several caveats and negates certain tax benefits, such as deducting property taxes or mortgage interest.

Until April 26, only three publicly traded companies warranted a coveted triple-A bond rating. But on that day, the number fell to two when Standard & Poor’s downgraded the rating of ExxonMobil (symbol XOM) to double-A-plus. How did stock investors react? Essentially by letting out a collective yawn. The stock actually rose on the day the downgrade was announced, by all of 30 cents a share.

Sure, the energy giant’s debt load has more than tripled over the past two years. And yes, lower oil prices drag down the bottom line. But this is Exxon we’re talking about—a company that supplies about 4% of the world’s energy needs, producing the equivalent of more than four million barrels of oil and natural gas a day. Most energy producers would be thrilled to earn a double-A rating. S&P may have landed a punch with its downgrade, but it will take a lot more than that to knock down Exxon’s stock. (Moody’s, which continues to rate Exxon triple-A, put it on a negative ratings outlook in February and may be next to downgrade the firm. The other remaining triple-A-rated companies, according to both S&P and Moody’s, are Johnson & Johnson and Microsoft.)

In fact, Exxon is one of the few stocks likely to deliver solid returns for the next decade or more. With a market value of $367 billion, the Irving, Tex.-based firm towers over every other energy producer, both globally and in the U.S. Analysts expect the company to haul in $222 billion in revenues this year. That’s down sharply from record sales of $468 billion in 2011, but it still beats almost every other company on the planet. At current production rates, the firm’s proven oil-and-gas reserves would last for the next 16 years.

Smaller energy companies offer more growth potential. And their stocks would surge much more if oil prices jump back to $70 per barrel or more, up from the current price of $45.30. Yet most major producers have posted steep losses as oil prices crashed, taking their stocks down by 30% or more. Exxon has managed to stay profitable, reporting $16.1 billion in net income last year. The stock, at $88.49, has held most of its value, too, trading just 15% below its all-time high of $104 a share, reached in June 2014. (All current prices are as of April 27.)

A good source of dividend income

Amid the carnage in the oil patch, Exxon even managed to hike its dividend in 2015—the 33rd straight year it had done so. Its stock now yields 3.3%, well above the 2.2% yield of Standard & Poor’s 500-stock index. Exxon announced another dividend increase on April 27, hiking its quarterly payout from 73 cents a share to 75 cents. Although profits have come down sharply, the company reported first-quarter results on April 29 that beat Wall Street forecasts.

Even though Exxon may not have much growth in its tank, the company should generate piles of cash. Indeed, oil doesn’t have to budge much above current prices for Exxon to maintain current production levels and fund its dividend with profits from oil-and-gas and refined product sales through 2020, according to Bank of America Merrill Lynch. If the price of oil rebounds into the $70s, Exxon’s financial picture would look much brighter.

Exxon does face some steep challenges. After spending heavily on acquisitions, share buybacks and production in recent years, Exxon now carries an estimated $36.2 billion in long-term debt, up from $11.7 billion in 2014—one reason S&P downgraded the firm. That wouldn’t be so bad if the company wasn’t spending more than it’s making on an operating basis. Yet Moody’s expects Exxon’s capital expenses and dividends to exceed its operating cash flow by about $10 billion in 2016. Moody’s expects Exxon to remain in the hole in 2017, albeit at a diminished level.

The future looks bright

Long-term, Exxon will have to spend more heavily to replenish its reserves. Exxon replaced just 67% of its reserves in 2015, largely because of a decline in natural-gas drilling in North America. The company has replaced 115% of reserves over the past decade, and it will need to boost drilling sharply just to replenish 100% of the oil and gas it extracts.

Buying smaller energy producers or snapping up their assets would help the firm refill its coffers. Still, Exxon cut spending on exploration and production as oil prices sank; the company plans to shell out $23.2 billion this year, down from $31.1 billion in 2015. Eventually, Exxon will have to make acquisitions or ramp up spending, potentially choking profits if oil prices don’t climb.

Yet even in a low-price environment, Exxon’s competitive advantages should help it thrive. The firm’s cost of producing a barrel of oil or the equivalent amount of gas is lower than that of most major competitors. Its return on capital (a measure of profitability) has beaten every other big rival in recent years. Exxon’s refinery system—capable of processing 6.4 million barrels of crude oil a day—also benefits from lower oil prices, helping the firm’s overall profits stay afloat.

Exxon is likely to be the sole major producer to report a profit in the first quarter of 2016, says Merrill Lynch. Exxon earned 43 cents a share in the quarter. That’s a steep 63% decline from the $1.17 a share the firm earned in the same period a year earlier. Yet Exxon’s profits stand in sharp contrast to the rest of the industry, which is likely to be in the red.

Exxon will never be a sizzler in the energy patch. But the firm’s diversified businesses and financial resilience should make it a solid long-term bet. Over the past 15 years through April 27, the shares returned an annualized 6.4%, including dividends, compared with 5.2% annualized for the average large diversified energy company, according to Morningstar. Assuming that the world doesn’t stop burning fossil fuels, Exxon’s returns over the next 15 years shouldn’t be any different.

On the surface, bonds issued by state and local governments don’t pack much of a yield punch. But Uncle Sam generally doesn’t tax muni interest, which may be exempt from state taxes, too. Those breaks add up, especially for investors in the higher tax brackets. A 2% yield from a muni bond translates to a taxable yield of 3.3% for taxpayers in the top, 39.6% bracket. Add in a 3.8% Medicare levy on high-income earners, and the taxable-equivalent yield of 2% tax-free climbs to 3.5%.

Earnings for All

• Bank Accounts: 1%-4%
• Investment-Grade Bonds: 3%-5%
• Real-Estate Investment Trusts: 2%-6%
• Foreign Bonds: 3%-6%
• Preferred Stocks: 4%-7%
• Closed-End Funds: 5%-11%
• High-Yield Bonds: 6%-8%
• Master Limited Partnerships: 5%-11%

Even after a strong two-year run—with high-quality tax-free bonds returning an average of 9.1% in 2014 and 3.3% in 2015—the market still looks “a little cheap,” says Hugh McGuirk, head of municipal investments at T. Rowe Price. After taxes, muni yields exceed those of Treasury bonds with similar maturities. And despite headlines about states and other jurisdictions with shaky finances—notably Illinois and Puerto Rico—almost all muni issuers honor their obligations. Individual muni bonds default at a rate of less than 0.2% a year, which is well below the default rate for high-quality corporate bonds.

Risks to your money. Credit-rating cuts could send bond prices spiraling. States with a “negative” ratings outlook now include Alaska, Louisiana, New Jersey and Pennsylvania, according to Moody’s. Rising interest rates would lower the value of existing bonds and depress share prices of muni funds (though higher interest payments would offset the losses over time). Inflation may eat away at the value of your principal and interest payments.

Hire a pro. Residents of high-tax states should buy funds that hold bonds issued by their state or local government. Two top mutual fund choices for California and New York residents are Vanguard California Long-Term Tax-Exempt (symbol VCITX, yield 1.9%) and Vanguard New York Long-Term Tax Exempt (VNYTX, 1.8%). If state taxes aren’t a concern, go for iShares National Muni Bond ETF (MUB, $111, 1.5%), an exchange-traded fund that holds hundreds of munis issued by state and local governments across the country. T. Rowe Price Tax-Free High Yield (PRFHX, 2.8%) pays substantially more, but the mutual fund’s bonds have lower credit ratings and are more susceptible to default or a slump in price if their issuers run into financial troubles. (All prices and returns are as of March 31.)

Do it yourself. Individual bonds can be a good bet if you hold them to maturity. But you should take this route only if you can plow in at least $50,000, spread over several bonds, in order to stay well diversified. A San Diego Redevelopment Agency bond, rated double-A, recently yielded 2.5% to maturity in 2027. And a Chicago O’Hare International Airport revenue bond, rated single-A, yielded 3.4% to maturity in 2031. Neither bond can be called, or redeemed, until 2025, and their issuers should generate enough steady revenue to meet their interest payments until the debt comes due, says Dusty Self, comanager of the RidgeWorth Seix Short-Term Municipal Bond Fund.

Next: Investment-Grade Bonds to Earn 3% - 5%