Investments that can provide a regular source of income

Many investors seek a reliable stream of income, especially as they near retirement age. There are many different types of investments that can provide fixed income, and in this brief introduction I will highlight a few of my favorites. I’m specifically focusing on highly liquid investments that are easy to understand and buy or sell, and avoiding more specialized income investments such as real estate rental property.

Bond investments can provide a very predictable source of income, because they pay interest on a regular basis. If you buy individual bonds, the coupons may pay every 6 months or once a year. But you can also own a diversified portfolio of bonds through mutual fund or ETF investments, many of which make monthly dividend payments. Investment rates have recently been relatively low, so you may want to take a look at owning at least some high yield bonds in your portfolio. While these are more volatile than higher grade bonds, the difference in the interest rate they pay is currently as much as 7 or 8 percent per year. If you are concerned about inflation, there is a type of bond that protects you against this also: Treasury Inflation Protected Securities, better known as TIPS. These pay an interest rate that adjusts to some percentage above the current rate of inflation.

Dividend paying stocks can also provide good income and the key consideration in this type of investment is to find relatively high quality and stable stocks that still offer decent yields. As stock market valuations rise, this becomes more difficult to do, but it is certainly possible. Stocks of solid companies that currently offer a 4 to 6 percent dividend yield include: AT&T, Lockheed Martin, and Seagate Technology. Even technology stalwarts like Intel Corporation and Microsoft, which in the past were not known for paying dividends, are now yielding over 3 percent. You can also look into Real Estate Investment Trusts (also known as REITs) as a source of dividend income. REITs are also stocks, but they are legally structured in such a way that the company has to pay out a majority of its profits as dividends to the shareholders (in return for some corporate tax breaks from the IRS). REITs typically invest in commercial or residential real estate buildings, so you can think of them as landlords: companies that own a portfolio of malls, office buildings, or apartment complexes.

Of course every asset class has its good and bad periods, so if you are concerned about losses and require a steady stream of income, you should consider a tactical asset allocation strategy that invests in bonds.

Are high yield bonds risky investments?

High yield bonds are risky, but they’re not as risky as stocks. If you compare the historical returns and risk of U.S. stocks versus high yields bonds, you’ll find that high yield bonds in fact have a better return to risk ratio. That’s not to say that junk bonds are without any risk. To the contrary, during periods of poor economic performance, even a diversified portfolio of these securities has lost as much as 34 percent of its value. Still, that’s much better than stocks, which have lost more than 60 percent of their value during previous market crises, even if you hold a diversified basket or index fund of the highest quality U.S. stocks.

High yield bonds are risky in part because they are issued by corporations that have low credit ratings. If you buy individual junk bonds, they can be very risky. For example, if you have a large percentage of your investments tied up in a single high yield bond, and it defaults, then you can lose 100% of that investment, and that would make a serious dent in your portfolio.

But you can also minimize the risk in these securities by buying a diversified high yield mutual fund or index fund (ETF). There are two popular high yield bond ETFs: the SPDR Barclays Capital High Yield Bond fund (with ticker JNK), and the iShares iBoxx High Yield Corporate Bond Fund (which trades under the symbol HYG). These are both index funds, and while you’ll get the return of the index (minus annual expenses), this may not necessarily be the best way to invest in this market. Actively managed funds have the option in investing in more or less risky junk bonds. Some high yield bond funds hold relatively high rated bonds, while others consist of much more speculative portfolios. One fund that holds very high quality junk bonds is the Vanguard High Yield Bond Fund. It may not return as much as some of the others, but that’s the price you pay for sleeping a little better at night.

In investment, risk and return go hand in hand. If you want to benefit from the potentially higher returns of high yield bonds, you’ll have to also be willing to take on some additional risk.