Steady Income in Unsteady Times

By Lauren Young

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Illustration by Andy Potts

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With the subprime mess working its way into every back alley of the stock, bond, and money markets, this is a tricky time to be searching for income. Anyone looking for a steady paycheck from an investment portfolio in 2008 will have to negotiate a maze of falling interest rates, shrinking dividends, and potential bond downgrades.

But the turmoil means that income hunters willing to take on a little risk can reap significant rewards. "Some real opportunities for income have morphed out of these crazy markets that are really out of whack," says Jim Sarni, managing principal at Payden & Rygel, a money- management firm in Los Angeles.

Money managers and financial advisers see opportunities in municipal bonds, as well as in lesser-known corners of the stock and bond markets, such as master limited partnerships (MLPs) and trust preferreds (TRUPs). While cash was king for much of 2007, yields on instruments such as money-market accounts and certificates of deposit have dropped along with short-term interest rates. The typical one-year CD, for example, is yielding 3.48%, down from 3.79% last year, according to Bankrate.com (RATE). Still, for a government-insured deposit, it's not a bad deal.

Banks and other financial institutions are offering some juicy dividends right now, but many big investors are reluctant to load up on these high-yielding stocks, given the turmoil in the financial sector. "I question whether these companies are going to be able to increase dividends in this environment," says Bob Doll, global chief investment officer and vice-chairman for equities at BlackRock (BLK). Indeed, some money managers are worried that banks will be forced to cut dividends.

Bonds are a better bet, but the kind of bond that will deliver yield this year isn't a traditional choice. "The best yield opportunity in 2008 is tax-free munis," says James Swanson, chief investment strategist at MFS Investments in Boston. Because of their tax-exempt status, munis usually have lower yields than comparable U.S. Treasuries. But these are unusual times: Now, the typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni.

On 30-year bonds, the muni and Treasury yields are virtually the same—4.7% and 4.6%. To beat the 4.7% muni, an investor would have to get more than 7% in a taxable bond. "There is a huge opportunity to get some yield in the muni market right now," says John Miller, chief investment officer of municipal bonds at Nuveen Investments in Chicago.

While investing in tax-free bonds issued in your own state offers an added boost, be forewarned. The U.S. Supreme Court has heard arguments in a case that challenges the widespread practice among states of granting income-tax exemption on interest generated by in-state municipal bonds while taxing interest from other states' bonds. An adverse ruling from the court could roil the muni market.

More immediate is the concern about the financial health of bond insurers, such as MBIA (MBI) and Ambac Financial Group (ABK), two of the largest players. It's not the muni defaults that are giving them fits. Their woes come from investments they made in now- troubled mortgage-backed securities. Roughly half of the $2.5 trillion in muni bonds is insured.

Need even more juice from your investments? Check out master limited partnerships, which offer investors yields up to 9%. MLPs, which are mainly in the oil and gas sector, trade like stocks and by law pay out most or all of their cash flow in distributions. That allows them to escape corporate income taxes. MLP investors typically pay regular income tax rates—not the 15% dividend rate—on 20% of their cash distributions.