Where to Turn for Income in a Low-Rate Environment ; Tired of Paltry Returns from Money-Market Funds and CDs? Some Analysts Recommend Moving Up the Risk Curve to Invest in Junk Bonds and Real Estate Investment Trusts

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For small investors, getting a reasonable return from their savings can be frustrating. Today, many money-market funds pay about 1.2 percent. A one-year bank certificate of deposit averages less than 1.6 percent. Tying money up for two years in a CD boosts the return to about 2.1 percent, according to Bankrate.com.

But with inflation running at about 2.3 percent, even that rate means that real returns are negative.

Is there any possible relief? Yes, experts say, but only if investors move away from such supersafe investments.

"People should get used to being in a protracted period of low interest rates," says Ronald Kaiser, director of Bailard, Biehl & Kaiser, Inc., an investment-counseling firm in Foster City, Calif. "Those happy days [of high interest rates] are gone."

Nonetheless, there are investments that do offer higher yields, though at a higher risk. One is REITs (real estate investment trusts). Another possibility is junk (high-yield) bonds. In both cases, consider investing through mutual funds, since that's safer than purchasing them individually.

Mutual funds provide exposure to various types of REITs or a batch of high-yield bonds. Such diversity helps protect against losses sustained when a single REIT performs poorly or a company behind a junk bond goes bankrupt.

Right now, REITs are paying an average cash dividend of about 6 percent. Coupon payments on junk bonds run about 8 percent - better but riskier.

"The risk of default is very real in junk bonds," says Annette Thau, the author of McGraw-Hill's guide on fixed-income investments, "The Bond Book." "If investors want to invest in that sector of the market, you want to invest in a mutual fund."

Mr. Kaiser advocates putting a quarter to a third of an investor's portfolio into real estate. In fact, right now with interest rates so low, he sees REITs as a surrogate for investment- grade bonds.

To most investment planners, Kaiser's views are extraordinary if not revolutionary. But with today's low yields on better quality bonds, "there are serious questions as to whether bonds should play any role at all in any but the most risk-averse portfolio mixes," Kaiser says.

Bonds are a poor choice for investors right now because REITs offer a higher cash yield, Kaiser continues. That yield is relatively steady, he says, and the potential return over the next several years is double that of bonds.

His evidence: the yield for 10-year Treasury bonds for the past eight decades. (See chart.) When the interest rate at the start of the decade starts out low, the annual average yield for the next five years or for the entire decade is similarly low if not lower.

In the 1980s and 1990s, interest rates started out high and annual bond yields were rich. "But now we are back to the days when you get only 4 percent a year," Kaiser says. …