Alternatives to fixed-income low-interest rates
By Laura Bruce • Bankrate.com

Low interest rates on CDs and money market funds are a source of frustration for any investor, but if you're retired and counting on that income, low rates can make it tough to pay the bills.

"Tens of millions of Americans are getting half the income they got a year or two ago, while the investment community is applauding low interest rates," says Steven Evanson of Evanson Asset Management in Monterey, Calif.

You don't have to settle for low returns just because you don't want to invest all your money in the stock market, but it may be time to consider taking some risk.

We asked four experts for ways to get better returns without tossing all caution to the wind.

You'll notice that a couple of our experts recommend Vanguard funds. Vanguard is a rare bird in the mutual fund world. The funds' shareholders own its funds. Vanguard takes no profit from the funds. Because of this unique structure, Vanguard is known for having extremely low fees.

As with any investment, your return will vary depending on whether you hold the fund in a fully taxed account, a deferred-tax account or a tax-free Roth IRA.

Steven Evanson, Evanson Asset Management, Monterey, Calif.
"Don't be tempted by anything that's higher yielding than 6 percent or so and more than five or six years in maturity. People are tempted by high-yield, long-term bonds that have a lot of exposure to risk. If rates rise and you have 20-year bonds at 6 percent and you can get 5 percent in a money market and 8 percent on a 30-year bond, you won't be very happy.

"A reasonable yield today, unfortunately, is 5.5 percent to 6 percent, at most, for about five years. For a shorter duration, you can expect 2.5 percent or so a year, taxable yield.

"Look at Vanguard. It has no-load bond funds, top-rated corporate bond funds -- U.S. Treasuries, short-term or intermediate-term only -- a 50-50 mix is good. Short is one to two years; intermediate is four to five years.

"Some credit unions have very good yields on CDs. Capture some of the higher yields at four or five years out."

Peter Di Teresa, senior analyst, Morningstar.com
"Anyone on fixed income should have a significant portion of their portfolio in bonds. The key is to look for mutual funds that take on a little risk, but not too much more and that give you significantly more income and pay a higher yield than a money market or CD.

"Focus on two types of bond groups: ultra-short bond funds, around 18 to 24 months in duration, and short-term bond funds, about one to three and a half years. If you're willing to take on fractionally more risk, you might go with a short-term bond fund. They may be a little more volatile, but they'll typically give higher yields and higher overall return.

"The average three-year return for short-term bond funds is 5.7 percent. The average three-year return on ultra-short bond funds is 4.79 percent.

"If taxes are an issue, look for short-term bond funds that are protected from taxes in your state, especially if you're in California or New York. In New York there are even triple-tax-protected bond funds because some people will also be subject to city of New York taxes.

"You don't want to get a single state bond fund. There's no reason to buy one. Get a national municipal bond fund if you're concerned about taxes. Get one that's shielded from federal taxes and you'll get broad tax protection.

"Pay attention to a fund's record. Seek funds with low annual expenses, the cheaper the better. Expenses come straight out of money you'd otherwise pocket as an investor. Bond funds tend to not have very large returns, so pay as little as possible.

"The average expense ratio for an ultra-short bond fund and for a short-term bond fund is 0.9 percent. You can do considerably better than that. Look for ones that are half that. Be cheap.

SsgA Yield Plus (SSYPX): "It's a great money market alternative. It's an ultra short bond fund that doesn't take on much more risk than a money market fund but it does considerably better."

Strong Advantage (STADX): "This takes on some more risk because it ventures down into the lower tiers, not junk but a little riskier, and pays a higher yield as a result. When I say riskier, that's a relative term. None of these are very risky."

Vanguard Short-Term Federal (VSGBX): "This is particularly safe. It focuses on government-issued bonds; it's run in a very conservative style and it benefits, like all Vanguard funds, from very low expenses."

Vanguard Short-Term Corporate (VFSTX): "Investment grade; pays a higher yield."

Vanguard Short-Term Bond Index Fund (VBISX): "Also owns government bond issues and high quality corporate bonds. You can buy and hold and draw income off them."

Corey Redfield, chief fixed-income strategist, USBancorp Piper Jaffrey, Minneapolis, Minn.
"Too many seniors don't believe in investing in anything longer than a year. People need to look at risk. They think if they buy a security that's longer than one year it's very risky. If they put the money in a money market, there's no risk to principal, but there's no income. That's risk.

"There are a lot of people who have the perception that a CD is safer than a Treasury. A Treasury is as safe as a CD; it's just a different way of investing. Buy Treasuries or certain agencies*. They're state tax-exempt, where with CDs you have to pay taxes.

"Take your two-year CD rate, 3.44 percent. The two-year Treasury is 3.51 percent, so you're a few basis points ahead with the Treasury, but let's say the Treasury yield was the same as the CD. If you're in a moderate income bracket and paying 15-percent federal tax, and suppose you live in Minnesota where there's 6-percent state income tax; the combined tax bracket is 21 percent. A lot of people who depend on CDs probably use the standard deduction, so you can't even write your state taxes off your federal taxes. The CD, after taxes, would pay 2.72 percent. If they bought the Treasury at the same yield and only have to pay federal taxes because Treasuries are state-tax exempt, their after-tax yield is 2.92 percent. They picked up 20 basis points even though their yield is the same.

"Certain agencies are tax-exempt. Fannie Mae and Freddie Mac are not, so I would caution against putting them in a taxable account. But Federal Home Loan Bank and Federal Farm Credit Bank are state tax-exempt. If you bought a two-year agency at 3.75 percent, you're already 30 basis points better than a CD.

"You buy agencies through a brokerage; you buy Treasuries from the Treasury or through a broker.

"Treasuries pay semiannually, not monthly, so if you need monthly income, set up a portfolio that has different maturities. If you don't need the semiannual income, buy zero coupons and go out to three or four years. You can get a higher yield."

*Federal agencies, which are fully owned by the U.S. government, and Government Sponsored Enterprises, which are privately owned enterprises that receive federal sponsorship, are referred to as U.S. Agencies and are allowed to issue debt on their own behalf.

Jack McAllister, National Association of Real Estate Investment Trusts, Washington, D.C.
"Real estate investment trusts, REITs, can be a source of income for today's investors. REITs are currently paying an average of 6.5 percent on an annual basis. That income is based on the rental income these properties generate from their commercial real estate. It's a cash flow coming from contractual rents -- office buildings, industrial facilities. These leases can be 10 to 15 years in length.

"The cash flow from REITs tends to be stable, consistent and predictable. That's not to say there's no risk. Real estate is affected by the economy just like any other business. REITs pay out about 65 percent of their cash flow on average. That's a very good cushion. They're not taking every dollar they generate from rent to pay dividends.

"Unlike money markets, CDs or short-term bonds, the prices of REIT securities will fluctuate more widely. REITs should be viewed as an income alternative for a longer time horizon. Look to REITs for four years and beyond. But if you have to cash out, they're liquid; they're sold on the stock market.

"Buying an individual REIT produces more risk than buying a fund. You can buy a REIT mutual fund and buy a portfolio of diversified REIT shares run by a professional money manager. Morningstar tracks more than 50 dedicated REIT mutual funds.

"If you buy individual REITs, be sure to diversify among property types and geography. Analyze an individual REIT before buying just as you would any other company.

"REITs pay dividends quarterly. They can be reinvested."

For more information on REITs, visit the National Association of Real Estate Investment Trusts Web site.

-- Posted: March 19, 2002