Wary of Bonds? Some Income-Oriented Options

Many investors may be leery of investing in bonds these days, following recent sharp increases in interest rates that pummeled the value of many bonds and bond mutual funds.

There are other investment options for income-oriented investors. And some of these alternate investments tend to do well in an economic recovery, despite the fact that recoveries tend to boost interest rates and send the price of fixed-income investments south.

But be warned: Most of the options that offer reasonably high yields still put your principal at risk. The ones that don’t usually pay paltry returns. That said, here’s a look at the options for income-oriented investors who would like to consider beyond bonds:

Real estate investment trusts

Approximate yield: 6%-10%

Pros: Shares of REITs are traded on stock exchanges and pay generous dividends--they’re required to distribute 95% of their net income to shareholders each year.

Additionally, their share prices tend to rise when the economy improves. That’s because they invest in shopping centers, apartments and office buildings that rent more easily--and at better rental rates--when companies are expanding and retailers boast brisk sales. The properties owned by REITs also become more valuable in a recovery.

Cons: Share prices and dividend yields get hit when the economy sours or when the commercial real estate market is overbuilt. While REITs boast an average annual return of 13.8% over a 20-year period, the depth of their bad years can be pretty deep.

When the real estate market soured in 1990, for example, REITs posted a total loss of 17.35% even after taking into account the 11.34% dividend yield that year, according to the National Assn. of Real Estate Investment Trusts in Washington.

Out-of-favor, dividend-paying stocks

Approximate yield: 4%-8%

Pros: The stock market has bludgeoned the shares of energy companies, utilities and drug and tobacco companies to such an extent that many of these companies are paying dividends that yield more than 4%, notes Geraldine Weiss, editor of Investment Quality Trends in La Jolla. If the stock market comes back--and these industry groups participate--investors could find themselves with double-digit total returns.

Cons: Each of these industry groups has been hit for a reason. Energy companies suffer with a decline in oil prices--a drop that OPEC has been unable to check. The stock prices of many utilities dropped about 25% from their highs when interest rates began to rise, because these companies borrow heavily and tend to suffer--or, at least, grow more slowly--in high-rate environments. They’re also not economically sensitive, so they don’t benefit from economic recovery.

Meanwhile, drug and tobacco companies look vulnerable to the political climate that has turned against them and now threatens to limit their profits or tax them--albeit indirectly--more heavily.

In short, stock prices in all of these out-of-favor industries could fall further just as easily as they could rise. Worse still, if a company that normally pays high dividends cuts the dividend payout, it not only trashes investors yields, it trashes the price of the stock. The value of IBM shares, for example, was cut in half when the company slashed its dividend payout a year ago.

Single-premium deferred annuities

Approximate yield: 3%-6%

Pros: Single-premium deferred annuities, offered by insurers, allow you to invest a lump sum that will accrue interest for several years before “annuitizing.” At that point, the investor will get regular payments that represent interest and some return of principal. Generally, consumers can opt to defer taxes on the earnings within the policy until the money is pulled out at retirement.

One benefit is that you get a life insurance element that can benefit your heirs if you die before you start to take regular payments out of the investment.

Cons: They provide no current income. Generally speaking, the first opportunity you would have to pull your money out would be seven to 10 years after it was invested. If you pull funds out before then, you’re generally subjected to surrender fees that can amount to 10% of your investment. Those who withdraw funds before retirement may also be forced to pay tax penalties.

Bank certificates of deposit

Approximate yield: 2%-5%

Pros: Your principal of up to $100,000 is completely safe because it is guaranteed by the federal government. And with a certificate of deposit, you can lock in a yield for a specified period of time.

Cons: The rate of interest is poor and tends to rise more slowly than market interest rates. That’s because banks really don’t need your deposits unless loan demand is strong and they can’t find cheaper money elsewhere. (Banks make their profits on the “spread”--the difference between what they charge for loans and what they pay for deposits.) That makes rates for bank deposits, whether it’s a passbook account or a certificate of deposit, very slow to rise.

Money market mutual funds

Approximate yield: 2%-4%

Pros: Your principal is safe--backed by short-term government obligations--and easily accessible. Interest rates on these funds are also sensitive to changes in market rates, so if market rates rise, so do the rates on money market funds.

Cons: The interest earnings rarely allow investors to keep pace with the rate of inflation. Most experts say money market mutual funds are a great place to park your money for short periods when your investment options look bleak. But if you leave your money in these funds for any length of time, you’ll end up with less spending power when you take the money out than you had when you put the money in.