Earn 8% or More

Investors in search of high income had the rug pulled out from under them this past year. A frantic rush to buy Treasuries, despite obscenely low yields, undermined the value of other income-oriented investments, including junk bonds, mortgage securities, municipal IOUs and even some supposedly safe ultra-short-term bond funds. But as the headlines shift from the credit crunch to the timing of an economic recovery, income investors can exhale.

That's because in the hunt for yields of 8% or better, you'll have company. All those buyers will at least maintain, and perhaps push up, prices of income-oriented investments. "A lot of money in low-yield securities has to move out," says Bill Larkin, a fixed-income investor at Cabot Money Management, in Salem, Mass. What he means is that money-market funds at 2% and Treasury bonds at 4% cannot keep you square with the cost of living or preserve the purchasing power of your savings.

As if on cue, investors began exhibiting a greater appetite for risk this spring. They returned to medium-grade and low-rated corporate bonds, bank-loan funds and real estate investment trusts. They even started to nibble on leveraged closed-end funds. "All the stressed areas are up from their lows," says Bill Berno, who runs Aegis High Yield fund and has 30 years of experience looking for undervalued and unappreciated income securities.

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From the perspective of the economic cycle, the recovery makes sense. Like stocks, many high-income securities tend to hit bottom in the middle of a recession. That's when forward-looking, patient investors get interested, as they anticipate better times ahead.

Meanwhile, the commodities boom continues to reward yield seekers. Oil and natural gas royalty trusts, pipeline partnerships and funds that focus on emerging-markets bonds (most issued by nations getting rich off of agriculture and natural resources) are protected from Wall Street's credit angst. Oil is overdue for a correction, so prices of oil-related income securities are falling from multiyear peaks. But even if crude, which fetched $126 a barrel in mid May, slips to less than $100, energy trusts will still pay high dividends.

We describe eight investing categories that produce good-to-great current returns. The categories are listed in descending order of risk. Bear in mind that in the world of income investing, risk is a slippery concept. Holding a 30-year Treasury bond is perilous, but not because the government could go bust. Rather, it's because the bond will lose value if inflation accelerates and interest rates rise (bond prices move inversely with interest rates and yields). REITs and junk bonds are up because bargain hunters have concluded that the worst of the credit crisis is over and that the economy will soon recover. If they're wrong, real estate and junk will give back recent gains, and then some.

Closed-end income funds

Since March, the share prices of many closed-end bond funds have leveled off after shedding as much as half of their value. This is a good sign. For example, look at First Trust Strategic High Income (symbol FHI), which borrows to invest in bank loans, mortgage-related securities and junk bonds. Its share price plunged from $20 in early 2007 to less than $10.50 eight months later, as its underlying assets fell victim to the credit crunch and the real estate recession. But the shares have rebounded to $12.25, and the fund's net asset value per share, now $10.38, has stopped crumbling (unless otherwise noted, all figures are to May 12).

But even as the fund was collapsing, it kept paying out 16 cents a month. Based on the current share price, the payout (which doesn't require borrowed money or represent a return of capital) comes to a yield of 15%. We generally don't recommend closed-end funds selling at 18% premiums to NAV, but First Trust's yield is too luscious to pass up.

The universe of closed-end funds is full of similar deals. If you don't think the credit picture is improving or that real estate, junk bonds or mortgages have seen the worst, the pickings are slim. But for an optimist or a contrarian, prices are cheap. At $18.28, Denali fund (DNY) (formerly Neuberger Berman Real Estate Income fund) trades at a 9.5% discount to its NAV. New management took over last year and has boosted the monthly payout from 11.5 cents to 19.5 cents, although the extra income comes from capital gains, not dividends. Denali is selling some long-held REIT shares as it converts from a real estate fund to a general, but leveraged, stock fund. But even at the 11.5-cent rate, Denali yields more than 7% and offers recovery potential. A year ago, the fund's shares traded for nearly $30.

Junk bonds

After a rough start in 2008, junk bonds rebounded smartly as the credit crunch eased and investors began to feel more confident that the economic downturn wouldn't be severe. The average high-yield corporate-bond fund returned nearly 3% in April and was up 0.5% year-to-date.

One plus for junk bonds -- those rated below BBB by Standard & Poor's and below Baa by Moody's -- is that they're relatively scarce in finance, housing and retail, the current trouble spots. Moreover, says Aegis manager Berno, prices of junk bonds are now benefiting from investors' renewed willingness to own lower-quality assets. Yet the yield gap between junk and Treasuries, six percentage points in mid May, is wide enough to suggest that the rally has more room to run.

Because defaults and downgrades are more common in high-yield than in other bond classes, you should use a fund to invest in this category. Metropolitan West High-Yield Bond (MWHYX), Payden High Income (PYHRX) and TCW High-Yield Bond I (TGHYX) are fine choices. Each boasts low expenses, is well diversified and yields 7.7% or better. And each is in the black so far in 2008.

Energy income trusts

Expect the world's growing thirst for energy to keep oil-and-gas prices high. That's why royalty trusts, which trade like stocks, are just the right fuel for your portfolio. Barring a collapse in energy prices, they should continue to perform well for years.

The concept is simple: These trusts pass to shareholders all of the income from their interests in producing oil-and-gas fields. Part of the return is taxable at ordinary rates and part is tax-deferred. The trusts tell you what's what at tax time. In either case, you get a monthly or quarterly distribution that typically amounts to a yield of at least 8% and often shoots into the double digits. Many of the trusts are trading near multiyear highs, though, so don't expect the 20% total returns they generated in the first four months of 2008 to grow to 30% or 40% by year-end.

Payouts vary with the prices of oil and gas, so figuring yields is tricky. Share prices also tend to respond to moves in oil and gas, so trusts are well suited for dollar-cost averaging. Take BP Prudhoe Bay Royalty Trust (BPT), which owns a slice of BP's Alaskan oil output. It started 2008 at $80 and climbed to $97 in mid May as crude continued to soar. Last year, BPT shares traded for as low as $55, but the quarterly payout never fell below $1.54, so the yield stayed above 10%. (The latest dividend, paid in April, was $3.04 per unit.)

All told, about two dozen royalty trusts trade in the U.S. They yield 6% to 16%, with gas giants, such as San Juan Basin (SJT) and Cross Timbers (CRT), at the low end and Canadian oil-and-gas trusts, such as Enerplus (ERF) and Harvest Energy (HTE), near the maximum.

Shares of Canadian trusts have steadied since Canada amended its laws in 2006 to make the trusts' tax status more like that of corporations, effective in 2011. The strong Canadian dollar has offset the tax shock, as have increased oil production, high energy prices and the potential of Alberta's oil-rich tar sands. It's smart to mix a Canadian trust or two into your collection of energy-income shares.

Ocean-shipping fleets

The U.S. economy may be slumping, but the global transport of oil, liquefied natural gas, coal, iron ore, steel, grains and other high-value cargoes continues to surge. In the first quarter of 2008, for example, the volume of goods on containerships traveling from Asia to Europe increased 12%.

This is good news for Seaspan (SSW), which owns a fleet of 29 containerships, with 39 more on order over the next three years. Seaspan has long-term contracts for moving freight on all its ships, including those still under construction. Chief executive Gerry Wang says the company should have no trouble raising dividends 5% to 6% over the next two years and possibly at a faster rate afterward. The stock, which at $27 yielded 6.9% in mid May, has delivered double-digit total returns each year since Seaspan went public in 2005.

Seaspan is among 20 shipping companies that rely on long-term, fixed-price contracts with shippers to ensure steady cash flow. They then distribute a high percentage of the cash flow to shareholders. The stocks generally yield 8% or better, although a few companies are using their excess cash to expand or to retire debt rather than raise dividends.

Genco Shipping & Trading (GNK), whose ships carry coal, steel and iron ore to China, just boosted its quarterly dividend from 85 cents to $1 a share. It could afford to pay out twice that, but chief financial officer John Wobensmith says Genco is limiting dividends to reduce debt. Since Genco's stock has doubled in a year, to $75, it yields just 5.3%. But that tells you business is booming. "The economic situation in the U.S. doesn't have a lot to do with bulk shipping," says Wobensmith. "It's the buildup of Chinese infrastructure." If China's economy implodes, all ships will sink, metaphorically speaking. Until then, stick with shipping stocks.

High-yield property REITs

Junk bonds yield more than high-quality corporate debt to compensate for their lower quality and greater potential for default. But high-yielding REITs aren't necessarily low-quality investments. REITs that offer well-above-average yields tend to be small and specialize in unusual types of properties. They don't own trophy office towers or fancy malls, which tend to attract big-money investors whose buying pushes up prices (and pushes down yields) of more-traditional REITs.

For high yields and safety, check out REITs that own hospitals, nursing homes, medical office buildings and other health-care facilities. This group yields more than other REIT categories because big property operators generally don't find health-care facilities appealing and it's hard to adapt the buildings to other uses. There's also the concern that pressure on Medicare and Medicaid spending could hurt medical providers and have negative consequences for health properties, although politicians dislike tampering with these popular programs.

Attractive health-care REITs include Cogdell Spencer (CSA) and Medical Properties Trust (MPW). Both stocks yield more than 8% and trade at or below the net asset value per share of their holdings.

Some REITs in out-of-favor real estate sectors also pay well. Shares of First Industrial Realty trust (FR), a national developer and operator of warehouses and light industrial buildings, more than doubled between November 2002 and November 2006 but have since fallen 33%, to $30, over concerns about flat rents and the firm's high debt. The stock trades below First Industrial's net asset value per share and pays 10%, one of the highest yields among long-established REITs. There is still ample cash flow to maintain dividends.

Pipelines

Here's a way to get yields of 6% or more from oil and natural gas (and maybe some growth, too) without having to worry about which way energy prices are headed. Pipeline operators, organized mainly as master limited partnerships, are reliable dividend payers that offer a bonus of regular payout increases.

Pipeline operators charge a regulated toll to move commodities from one point to another. Unlike the old phone and electric monopolies, though, pipelines face competition. A lot of new projects are in the works (maybe too many) to move natural gas from Texas, western states and Canada to hub terminals in or near major cities and to connect with coastal refineries and liquefied-natural-gas terminals. Low interest rates help this industry because it takes billions of dollars to build and maintain these networks.

Traditionally, pipeline MLPs yield about two percentage points more than Treasury bonds and also offer appreciation potential. But it's the cash payouts that determine the share prices. Treasury yields are sure to rise, so it's important to choose pipelines with a long history of substantial dividend increases. Shares of pipeline MLPs that consistently boost payouts should hold up well in a rising-interest-rate environment (otherwise, share prices are likely to fall to maintain their normal yield advantage over Treasuries).

Solid, established operators include Enterprise Products Partners (EPD), Kinder Morgan Energy (KMP), Magellan Midstream Partners (MMP), and Plains All American Pipeline (PAA). All have long histories of boosting their payouts and all currently yield 6% to 8%. A tip: Don't own MLP shares inside an IRA. There are potentially nasty tax consequences.

Emerging-market bonds

The days of double-digit yields and steady price appreciation from bonds issued in developing nations are gone. As ratings agencies have upgraded emerging economies and investors have poured money into their bonds, yields have shrunk dramatically. But bonds from Brazil, China, India, Indonesia, Mexico and Russia, to name a few, are still sources of superior income and provide diversification benefits to boot. And the countries are far stronger than they were in the 1980s and '90s, substantially reducing the possibility of default. In a sign of the times, Standard & Poor's recently upgraded Brazil's debt to investment-grade status.

Rising commodity prices, a headache for most Americans, have been a blessing for many emerging nations. For instance, Brazil, Mexico, Russia and Venezuela are big oil producers. A crash in oil prices would hurt their economies and would likely put pressure on their bonds.

For most people, funds make the most sense for investing in these esoteric bonds. Expenses tend to be high in this category, reducing yields, but longtime standby Fidelity New Markets Income (FNMIX) charges a reasonable 0.88% a year and pays 5.9%. Despite a horrendous 22% loss in 1998, the fund has returned 11% annualized over the past ten years. PIMCO Emerging Markets Bond D (PEMDX) is nearly as good a choice, although its expenses (1.25% annually) are higher and the yield (5.2%) is a little lower. The fund's older Class A shares (PAEMX), which levy a sales charge, have returned 13% annualized over the past decade.

Munis: rich returns from safe bonds

Tax-free bonds are no longer terrific deals. Now, they're merely good deals. The transformation culminated in early May, when the average yield of ten-year tax-exempt bonds, at 3.8%, reached parity with the yield of ten-year Treasury notes. (For a few months before, munis had actually yielded more than Treasuries, a rare state of affairs.) But municipals remain attractive, especially if you are in a high federal tax bracket and also live in a high-tax state, such as New York or California.

Consider, for example, New York City residents in the 35% federal bracket. They can buy bonds issued by the Port Authority of New York and New Jersey that yield 5.0% to a possible call (or early redemption) in November 2026. For these well-heeled New Yorkers, that's the equivalent of an 8.6% yield from a taxable bond. Port Authority bonds are rated AAÐ by S&P, so they are quite safe.

In fact, defaults among muni-bond issuers are rare, so you should give strong consideration to building your own portfolio of tax-free IOUs. After all, why should you pay a mutual fund up to 1% a year (sometimes even more) to invest in bonds that will mostly yield 4% or so? If you do buy your own bonds, you should build a laddered portfolio -- that is, one in which bonds come due at regular intervals. For safety, stick with general obligation bonds of states, counties and cities, or essential-service revenue bonds, which are used to construct and operate highways and water and sewage systems.

If you still prefer the convenience of a mutual fund, try Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25. It yields 3.4%.