Where to turn for income in a low-rate environment

For small investors, getting a reasonable return from their savings can be frustrating. Today, many money-market funds pay about 1.2 percent. A one-year bank certificate of deposit averages less than 1.6 percent. Tying money up for two years in a CD boosts the return to about 2.1 percent, according to Bankrate.com.

But with inflation running at about 2.3 percent, even that rate means that real returns are negative.

Is there any possible relief? Yes, experts say, but only if investors move away from such supersafe investments.

"People should get used to being in a protracted period of low interest rates," says Ronald Kaiser, director of Bailard, Biehl & Kaiser, Inc., an investment-counseling firm in Foster City, Calif. "Those happy days [of high interest rates] are gone."

Nonetheless, there are investments that do offer higher yields, though at a higher risk. One is REITs (real estate investment trusts). Another possibility is junk (high-yield) bonds. In both cases, consider investing through mutual funds, since that's safer than purchasing them individually.

Mutual funds provide exposure to various types of REITs or a batch of high-yield bonds. Such diversity helps protect against losses sustained when a single REIT performs poorly or a company behind a junk bond goes bankrupt.

Right now, REITs are paying an average cash dividend of about 6 percent. Coupon payments on junk bonds run about 8 percent - better but riskier.

"The risk of default is very real in junk bonds," says Annette Thau, the author of McGraw-Hill's guide on fixed-income investments, "The Bond Book." "If investors want to invest in that sector of the market, you want to invest in a mutual fund."

Mr. Kaiser advocates putting a quarter to a third of an investor's portfolio into real estate. In fact, right now with interest rates so low, he sees REITs as a surrogate for investment-grade bonds.

To most investment planners, Kaiser's views are extraordinary if not revolutionary. But with today's low yields on better quality bonds, "there are serious questions as to whether bonds should play any role at all in any but the most risk-averse portfolio mixes," Kaiser says.

Bonds are a poor choice for investors right now because REITs offer a higher cash yield, Kaiser continues. That yield is relatively steady, he says, and the potential return over the next several years is double that of bonds.

His evidence: the yield for 10-year Treasury bonds for the past eight decades. (See chart.) When the interest rate at the start of the decade starts out low, the annual average yield for the next five years or for the entire decade is similarly low if not lower.

In the 1980s and 1990s, interest rates started out high and annual bond yields were rich. "But now we are back to the days when you get only 4 percent a year," Kaiser says.

Even if long-term interest rates rise sharply in the next year - Kaiser doesn't expect that - the price of outstanding bonds will fall, reducing the return of a bond portfolio over the next decade. For institutional investors, such as pension fund managers, such a poor return "could be a serious problem," he says. They typically put 20 to 40 percent of their entire portfolio in bonds.

The REIT picture looks better to him. Since the start of this year, the average price of REIT shares has risen 29.4 percent, according to the composite index of the National Association of Real Estate Investment Trusts. That price rise has reduced the cash return on REITs to 6 percent from almost 8 percent in January.

Like corporate stocks, the share price of REITs varies according to their popularity with investors. Short-term investors need to be aware of that risk. REIT share prices declined in both 1998 and 1999. Though their handsome cash dividends continued, REITs looked like a timid investment compared with stocks in those boom years.

This year, REITs have done better than the 16.5 percent return of the Dow Jones Industrial Average and the 19.8 percent of the Standard & Poor's 500 stock index.

A 10-year Treasury note currently pays about 4.38 percent. But because of a modest rise in interest rates, these bonds have yielded investors only 0.62 percent if they were bought at the start of the year and sold in mid-October.

Although REIT share prices could fall again, Kaiser notes REIT shares sell for about 12.5 times their earnings, while corporate stocks are selling for about 20 times their earnings.

As for junk bonds, with signs the economy is picking up, their prices have risen quickly in recent weeks. Investors presumably feel the prospects of failure for the companies issuing these bonds have started to shrink. But how much longer the junk-bond rally will continue remains an open question.

"Would an investor now be buying into the top of the market for a high-yield bond fund?" asks Andrew Clark, a research analyst at Lipper Inc., a New York firm that tracks mutual-fund performance.

If an investor doesn't care about share-price volatility, but only about the immediate coupon yield, then a junk bond fund may be more suitable.

"Now is not as attractive a time to invest in junk bonds as two years ago," cautions Ms. Thau. If investors want their high yield, they should buy a mutual fund with no sales load, she says.

Shares in a junk bonds should be only a small percentage of a large portfolio, she suggests. Though the bond coupon yield may be high, if an investor had to withdraw money during an emergency at a time when those shares' price were down, they could lose money overall.