Investing in a Low-Rate Environment

To combat the worst recession since the Great Depression, the Federal Reserve lowered interest rates to close to zero several years ago and intends on keeping them there for the foreseeable future. While low interest rates are a boon for folks who want to take on more debt in the form of automobile loans or mortgages, they have become a thorn in the side of investors who are stuck trying to make money with these paltry rates. This so-called financial repression will be a continuing challenge, at least until rates start heading back up, but there are ways you can squeeze a bit more return out of your investments.

Reach for yield
Investors who are in or close to retirement need to make fixed income securities a primary feature in their portfolio, regardless of current low rates. But with yields on 10-year Treasuries hovering between 2% and 2.5%, it's hard to get blood from a stone.

That's why investors may need to get a little bit creative in the search for yield. While you should devote the majority of your bond holdings to low default-risk bonds like Treasuries and higher-quality corporate bonds, there may be room in your portfolio for some high-yield action. Lower-quality, or junk bonds, can be risky stuff, but with the economy improving, the risk of corporate defaults has subsided significantly.

If you're on the more conservative side of the risk spectrum, don't venture too far into high-yield territory. Limit junk bond exposure to no more than 10%-15% of your bond allocation. Two of the most popular high-yield funds around are SPDR Barclays Capital High-Yield Bond ETF (NYS: JNK) and iShares iBoxx $ High-Yield Corporate Bond ETF (NYS: HYG) , both of which feature a 7.3% yield. Just remember that these funds can lose money in a downturn -- in fact, the SPDR fund lost one-quarter of its value back in 2008's bear market.

To be fair, a lot of money has made its way into the junk bond sector in recent months, so don't expect returns to look as good as they have recently. But high-yield bonds should still offer reasonable returns along with bigger yields than those available on higher-quality issues.

Diversify your perspective
While most investors tend to have a more U.S.-centric bond portfolio, you're leaving a lot of money on the table if you ignore all the fixed-income opportunities beyond U.S. borders. So think about adding in a small allocation to a fund that looks overseas for fixed-income opportunities. One solid actively managed fund that does this is Loomis Sayles Global Bond (LSGLX). This fund invests in foreign government and corporate bonds in both developed and emerging markets. Over the past 15-year period, the Global Bond fund has posted an annualized 7% return and sports a 4.2% yield.

If you want a cheaper way to get global bond exposure, there are some exchange-traded funds that fit the bill. For corporate bond exposure, the SPDR Barclays Capital International Corporate Bond ETF (NYS: IBND) is a reasonable choice, with its 0.55% expense ratio. For investors looking for exposure to sovereign debt, the SPDR Barclays Capital International Treasury Bond ETF (NYS: BWX) will only set you back 0.50% in expenses a year. Again, foreign bonds as a whole are riskier than domestic bonds, so set your sights low when making your allocations, and don't load up on this area, especially if you are in retirement already.

Plug in some stocks
Of course, if you're still not feeling the love from low-yielding bonds, there is another potential source of income generation -- dividend stocks. Dividend-producing stocks have certainly been popular as of late, no doubt thanks in part to investors' frantic search for yield. But there's still some room for these stocks to run.

While investors can successfully use dividend stocks to boost their portfolio's yield, it's important to remember that these are stocks -- not bonds. That means more volatility and a greater risk of loss, so again, make sure you're not substituting dividend-paying stocks for large portions of your bond portfolio.

While you can spend your time seeking out individual dividend payers, the quickest way to attack this issue is to get a broad basket of attractive dividend-producing stocks in one stop. Here, an ETF like SPDR S&P Dividend (NYS: SDY) , with its 3.1% yield and 0.35% price tag, is a solid choice. If you want to minimize costs even more, Vanguard Dividend Appreciation ETF is another option. This fund comes with a super-low 0.18% expense ratio but a lower 2% annual yield.

In the end, investors should be careful when reaching for extra yield. There are ways to adjust your portfolio around the margins by sprinkling in riskier asset classes like those discussed above, but no one should abandon the core of his or her fixed-income portfolio. Bonds may not be yielding much nowadays, but they are still the best way for investors to protect their hard-earned capital and reduce overall volatility.

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At the time thisarticle was published Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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