Two Ways to Find Income

08/11/2008 12:00 am EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of the Independent Adviser for Vanguard Investors, finds two funds that offer a slightly higher return with not much more risk.

Unfortunately, with interest rates so low, “income” is awfully hard to find. And when you consider that inflation has been on the rise, real returns for many bonds are practically nil. That’s especially true for seniors whose consumption patterns differ from the average American’s.

Medical care CPI, for instance, has gone up 4.5% a year since 1999, outpacing inflation by 1.5%. Health insurance premiums are through the roof, rising at more than twice the inflation rate. How’s a Treasury bond yielding 4% going to help pay for your bypass surgery?

“Income” doesn’t necessarily equal interest paid on bonds or dividends paid by stocks. You don’t pay for groceries with income—you pay with cash. That cash could be generated by capital gains.

So, why not fund your retirement with stocks? Historically, stocks have proven to be the best inflation hedge, edging out the CPI’s 4% annualized rate over the past 30 years by more than eight percentage points.

One fund that could be a real winner in the search for income is Vanguard High-Yield Corporate (VWEHX), which currently yields upwards of 9% while having a BB credit rating, one full grade above the junk bond fund category average.

Because of the fund’s less aggressive profile, it tends to underperform in bull markets and outperform during bears. In this regard, it is the perfect vehicle for seniors looking for a lower-risk entry into this sector of the bond market, which is about the only one paying decent yields right now.

A similar case can be made for Vanguard High-Yield Tax-Exempt (VWAHX), which has an average credit quality of A and yields 4.50%, equivalent to a 6.9% yield for an investor in the 35% income tax bracket.

Ideally, you would combine these funds with equity funds so your overall portfolio would continue to grow as you lived off of the bonds’ current income.

Instead of bonds, you could also consider investing in Vanguard’s best hybrid funds that hold a mixture of asset classes. Over the years Wellington, Wellesley Income, and Convertible Securities have all delivered better-than-bond returns with considerably less volatility than the stock market. (Of course, given their high taxable yields, you’d be better off keeping these in your retirement account than in a taxable one.)

If you have a decent-sized portfolio and just want to live off the income it generates without touching the principal, I would suggest you stick with High-Yield Corporate and High-Yield Tax-Exempt on the bond side for now.

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