Best New Money Moves – The New Way to Reel In Income

While you needed a Costco-size supply of Dramamine to survive the stock market’s choppy ride to nowhere both last year and over the past decade, you required no such relief when it came to your bonds — or at least one type of bond.

In recent years all you had to do was scoop up Treasuries to satisfy pretty much all of your fixed-income needs. And the easiest way to do that was through a single fund, a total bond market fund that invests mostly in Treasuries and other U.S. government-related debt. The Vanguard Total Bond Market index (VBFMX) fund, for instance, returned nearly 7% in 2011 and nearly 6% annually over the past decade, when U.S. stocks made you very little.

Now the bond market is approaching uncharted waters — or, more accurately, waters you’ve probably not seen in your investing career or even your lifetime. The very force that made the bonds so bountiful in recent years — sharply falling interest rates that boosted prices and drove up total returns — have pushed yields on 10-year Treasury notes down to 2%.

That is an important development for three reasons:

Real yields are now negative. In 2009, when Treasuries were paying you close to 3.5% (which seemed paltry back then), inflation was nonexistent. That meant that the 3.5% payout was completely intact. Today, Treasuries and even total bond market index funds — which are yielding a slightly more palatable but still modest 3% — are paying less than the rate of inflation.

“Treasury bond buyers are locking in a likely negative real rate of return for the next 10 years as inflation could erode one’s purchasing power at a clip far greater than the meager interest paid by bonds at this time,” says Darren Pollock of Cheviot Value Management.

Your total returns are under threat. There’s another problem. With Treasury yields at 2%, there’s not much room for interest rates to fall further, so there’s little hope for a big jump in bond prices. That means “your total return is now going to be a function of the interest you get,” says Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds.

Treasuries are yielding less than stocks. It may seem strange that you’re getting less income from your Treasuries than the Standard & Poor’s 500 index. For the first half of the 20th century, though, that was actually the norm. It wasn’t until the late 1950s, in fact, that investors began to earn the lion’s share of their income from their fixed-income portfolios. And if history is a guide, that means you might be in store for some disappointing bond returns in the coming years.

Get more income from stocks

As bond rates have sunk, dividend- paying stocks have begun to present interesting opportunities. Plenty of blue-chip shares yield 3% to 5%, exceeding the yields on many high-grade corporate bonds.

Take Microsoft (MSFT, Fortune 500). The tech giant’s stock throws off a 3% dividend yield, while most of its bonds pay lower fixed-interest rates. Yet Darren Pollock of Cheviot Value Management says Microsoft “has ample room to raise its dividend prospectively, trades for approximately nine times profits, and is growing its earnings at a very acceptable rate.” So would you rather own the stock or the bond?

How to do it: Despite the appeal of dividend payers, this is not an endorsement to sell your core bond portfolio and pile everything into equities. Stocks, no matter how attractive, are far riskier than bonds. Within your equity portfolio, however, you can tilt your focus.

If you have most of your blue-chip holdings in an S&P 500 fund, you’re collecting a dividend yield of around 2.1%. Move 20% or so of that slice into funds that emphasize payouts.

Focus on firms with a history of increasing dividends. Greg Thomas, whose investment firm, Thomas Partners, specializes in dividend stocks, found that companies that increased or initiated payments between 1971 and the end of 2010 had an annualized return of 14%. Dividend payers that didn’t increase payouts gained 9.9%, and firms that didn’t pay dividends returned 3%.