Trying to squeeze yield out of bonds in today's market has been an exercise in frustration for income-seeking investors. With yields near record lows, many have been turning to other avenues to increase their portfolio's income. Dividend-producing stocks have been one of the prime beneficiaries in this ongoing search for yield. Owning a well-diversified ETF that focuses on this sector, such as Vanguard Dividend Appreciation ETF (VIG +0.56%), can be a smart move for many investors. But there are some other areas of the market that offer relatively higher yields if you can live with a little bit more risk in some cases.
Municipal bonds
Municipal bonds have been attracting a lot of attention in recent months as the fiscal and political wrangling in our nation's capital has intensified. As many folks (probably correctly) foresee higher taxes in our future, muni bonds are being given a second look. Because income from municipal bonds is exempt from federal and, in some cases, state taxes, these securities are highly attractive, especially for investors in higher tax brackets. Muni bonds aren't right for every investor, so if you're in a lower tax bracket, be sure to run the numbers first, because you may actually be better off owning higher-yielding taxable bonds.
One of the most popular municipal bond ETFs is the iShares S&P National AMT-Free Muni Bond ETF (MUB +0.12%). With a low 0.25% price point, this fund is a quick and easy way to access this segment of the market. Although the fund's SEC yield is a modest 1.66%, that translates to a 2.75% taxable equivalent yield if you happen to be in the top 39.6% tax bracket. That's nothing to pop the champagne over, but it is better than what you can get with Treasuries right now. There are also higher-yielding muni bond funds available, like Market Vectors High-Yield Muni Bond ETF (HYD +0.03%). And while this fund sports an impressive 4.68% SEC yield, it also has an average effective duration of 10-and-a-half years, which means the fund will really get knocked for a loop when interest rates start rising. The iShares fund is lower-yielding, but has a more manageable six-year average duration. Investors should just keep in mind that they should never own municipal bonds in a tax-advantaged account like a 401(k) because the bonds lose their tax-exempt features.
High-yield bonds
Most investors aren't really getting a whole lot of bang for their buck if they're buying Treasuries. At last glance, the yield on a 10-year Treasury bond was a measly 1.86%. Nobody's getting rich off that. If you're willing to put up with a little bit of volatility and stretch for a bit more yield, high-yield bonds can be a good supplement to your core bond holdings. In this space, a fund like the SPDR Barclays High Yield Bond ETF (JNK +0.54%) can be a good option. This fund tracks the performance of the Barclays High Yield Very Liquid Index, which consists of lower-grade corporate bonds. The fund's low 0.40% expense ratio and 5.35% SEC yield make it an attractive option for high-yield exposure.
Of course, high-yield bonds can be a risky proposition, especially in times of economic distress. In fact, the SPDR fund mentioned above lost one-quarter of its value in 2008. After all, you don't get that higher yield for nothing -- bigger rewards require bigger risks. So funds like these shouldn't take up a lot of real estate in your bond portfolio. Instead, they should complement your lower-risk core bond holdings. Very risk-averse types should steer clear of this sector completely.
Preferred stocks
While stocks shouldn't really be viewed as substitutes for bonds due to their higher inherent volatility, preferred stocks can help bridge that gap between equities and fixed income. Because preferred stocks generally pay a fixed dividend, they have characteristics of both stocks and bonds, making them a unique hybrid investment. Owners of preferred shares have claims on the company's assets above those of common shareholders but below those of bondholders. Preferred stockholders usually aren't entitled to voting rights, but in exchange they are granted a yearly dividend payment. This dividend isn't guaranteed, but it still offers another source of income for yield-starved investors.
The iShares S&P U.S. Preferred Stock Index ETF (PFF +0.16%) comes with a hefty 6.45% SEC yield. While that certainly looks enticing, investors need to be aware that this fund is concentrated exclusively in the financial sector. So there is some very high sector-specific risk here. And while the financial sector has clearly rebounded from its most troubled days, all it would take is another downturn in the eurozone or here at home to send financials spiraling back down. And as with high-yield bonds, preferred stocks can lose a lot of money in the short run, so use a light touch here.
If you're willing to move out of your comfort zone a bit, there are some good alternatives for boosting the income-producing power of your portfolio. Just remember to use investments like these sparingly, not as a primary solution.
