Adding Dose of Income to Investment Portfolio

These days, it’s hard to find a financial advisor who will talk much about bonds and other income investments. They’d rather celebrate the stock market’s big gains. But income investments deserve at least a small place in every investor’s portfolio.

By now, most investors have heard they should invest their long-term savings in stocks. After all, stocks have delivered the greatest long-term returns and offer the best chance at staying ahead of inflation during the coming decades.

However, stocks are likely to be quite volatile. And though investors have been willing to ride out recent setbacks in stocks, they might act differently if a severe bear market takes prices 20%, 30% or even 40% lower. And what if stocks don’t rebound right away, as they have after recent corrections?

Some investors might find it hard to ride out even short-term stock market setbacks. For example, a middle-aged father with kids in college might need to tap his savings to meet current bills. Similarly, a retired investor who wants to keep a cushion for medical bills would be uncomfortable investing too much in stocks.

The solution is to invest at least some of your money in funds that can produce current income and protect your principal.

Such funds invest in a wide range of securities, including high-yield stocks and a variety of bonds and other fixed-income securities. These investments tend to hold up better than growth-oriented holdings during periods when stock prices are falling. Moreover, they provide current income that can bolster your portfolio’s performance when capital gains are scarce.

How much should you invest in income funds? A common rule is that long-term savings invested in income-oriented assets should equal your age expressed as a percentage: That is, if you are 30, invest 30% in income-oriented funds; at age 70, the percentage can climb to 70%.

But today many planners recommend a more aggressive approach if you are in sound financial shape and don’t mind some bumps and bruises in the pursuit of higher gains.

But whatever balance you choose between income and growth, you should try to select funds that will efficiently implement your strategy. Here are some funds that can add a dose of income to your investment portfolio.

* Investment-grade bond funds: These funds hold high-quality government and corporate bonds with little credit risk. Their share prices do fluctuate with interest rates, but you can minimize that risk by sticking with funds that hold short-term and intermediate bonds.

One good candidate is Stein Roe Intermediate Bond ([800] 338-2550; $2,500 minimum investment; no load). The fund’s average maturity is 8.4 years. Fund manager Michael T. Kennedy invests in a variety of investment-grade corporate and government bonds.

If you’re willing to take some more interest-rate risk, check out Vanguard Bond Index-Total Bond Market ([800] 662-7447; $3,000 minimum; no load). It tries to track the performance of the Lehman Bros. Aggregate Bond Index.

* International funds: Investing in foreign bond markets may sound like an odd way to add stability to your portfolio. But buying overseas bonds can reduce the risk of your income holdings, because they will be less dependent on the day-to-day fluctuations of the U.S. bond market. That said, make sure the fund you choose is broadly diversified and has a good track record.

Compass Capital International Bond Fund ([888] 426-6727; $5,000 minimum; no load) recently invested 58.5% of its assets in Europe, with the rest distributed primarily among Japan, Canada and the United States. The fund has generated annual gains of 9.4% during the last five years versus 5.9% for the typical international bond fund, with 38% less volatility.

* Multi-sector funds: Your best choice may be a fund that invests in different sectors of the bond market. Such funds sometimes shift their assets among a wide range of income investments, including high-quality and low-quality issues in the United States as well as developed and emerging overseas markets.

Multi-sector funds that make extremely large bets on a single type of security when they think it offers good value can be dangerous. But some entries in this category have generated superior returns with average risk by investing in a broadly diversified mix of income investments.

Dreyfus Strategic Income ([800] 645-6561; $2,500 minimum; no load) is a good example. It’s gained 8.6% annually during the last five years versus 7.8% for the typical multi-sector fund. Manager Kevin McClintock invests in a variety of bond sectors, including U.S government and corporate issues as well as some foreign debt.