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Maximizing fixed-income investing using alternative strategies

Paul Souders | Stone | Getty Images

With bond investors still skittish over interest rate risk, the search for alternative investment strategies that produce consistent income is on.

Noise that the Federal Reserve may start tapering its economic stimulus program prompted an exodus from bond funds this year, with capital outflows reaching $13.3 billion through Sept. 20, according to Trim Tabs Investment Research.

Rising interest rates are a threat to investors because they push bond prices lower, making them less valuable.

Amid the selloff, investors seeking yield are redirecting those dollars into equity and fixed-income securities—high-yield corporate bonds, real estate investment trusts, master limited partnerships, fixed-index annuities and dividend-paying stocks—that seek to mimic, if not mirror, government-backed Treasurys.

All, however, involve varying degrees of risk and could potentially upset the balance in an otherwise diversified portfolio.

(Read more: Investors have "alternative" options)

"We've tended to like equities more this year than bonds," said Stephen Freedman, co-head of investment strategy at UBS Americas. "Conservative investors should consider increasing their equity exposure moderately. However, they shouldn't conduct large allocation shifts that materially change the risk profile of their portfolio."

He said the urgency to deploy fixed-income alternatives has dissipated slightly in recent months as bond prices leveled off.

"Prices were artificially low, and now they reflect better where we are in the cycle," Freedman said. "The worst time to be in bonds is probably already behind us."

With rock-bottom interest rates having nowhere to go but up, however, price pressure in the bond market will likely continue, making high-yield corporate bonds an attractive option for fixed-income investors, he said.

High-yield bonds, also known as junk bonds, are debt obligations issued by private corporations with lower credit ratings.

The credit-rating agencies—Moody's, Standard & Poor's, and Fitch—have determined that these bond issuers are more likely, based on an analysis of their financial health, to default on interest and principal payments.

Such bonds reward investors for that increased risk by offering a higher interest rate than government bonds and high-grade corporates. The yield to maturity for the benchmark Bank of America Merrill Lynch U.S. High-Yield Master II index, for example, is currently 6.7 percent.

Diversified high-yield investments (bond funds) are a better bet for average investors, Freedman said.

(Read more: Alternative strategies for "average" investors)

"In a well-diversified basket, what matters is the portion of defaulting issuers," he said. "With aggregate U.S. default rates low [currently around 2 percent] and likely to remain low over the next year, given the improving economic outlook, default losses should not be very significant."

Moreover, Freedman added, the yield spread earned over Treasurys, which stands at about 4.7 percentage points, "more than compensates for this risk."

A less traditional but still viable option for income investors is a master limited partnership, or MLP, said Ryan Ely, an advisor for Capital Investment Advisors in Atlanta, which specializes in income-generating portfolios.

U.S. energy firms that own natural gas and oil pipelines have increasingly reorganized to form MLPs, which are publicly traded as units rather than shares of stock.

Such partnerships pay out most of their cash flow to investors, offering attractive yields of 6 percent to 7 percent and consistent dividends.

"If you're looking for a bond replacement, that's a pretty sweet deal," Ely said. "Income from MLPs has been incredibly consistent over the last 20 years, and we are still underbuilt on infrastructure in this country for pipelines, so there's room for growth."

Oil and gas production in the U.S. has "taken off like a rocket ship" in recent years, he said, and MLPs own the assets needed to transport the vast quantities of newly discovered oil and gas.

They are, however, complex from a tax-structure perspective.

Ely said the easiest way for retail investors to gain exposure is through exchange-traded funds (ETFs) and exchanged-traded notes (ETNs) sold on major stock exchanges, rather than by buying MLPs individually.

(Read more: Cramer: Folding new assets into MLPs)

Real estate investment trusts, or REITs, have long been favored for their predictable income stream, as they are legally required to distribute 90 percent of their taxable income to shareholders in the form of annual dividends.

Such trusts, which are bought and sold like stocks on the major exchanges, own—and, in many cases, operate—commercial real estate properties, enabling investors to gain exposure to the commercial real estate market through a liquid security.

REIT prices typically fall when Treasury rates rise, but Morningstar ETF analyst Abby Woodham said "that's not the end of the world," because REITs are trading at close to fair value.

"REITs have been increasingly popular over the past few years because they offer attractive yields, so they've been trading at a significant premium," she said. "Over the past few months, though, we've seen quite a bit of selloff, so if you're interested in REITs, now is a better time to buy than it has been in a few years."

REITs can be purchased individually, or through a REIT fund or exchange-traded fund, though buyers much conduct their due diligence.

Some are highly concentrated on certain segments of commercial real estate, such as shopping malls or office buildings, which make them more vulnerable to a downturn.

Also, as with all equities, there is no guarantee of dividends or price appreciation.

Using Ibbotson Associates' target model asset allocation, Woodham said the average investor should limit REIT exposure to between 3 percent and 5 percent of the overall portfolio.

(Read more: Cramer takes a second look at REITs)

Investors may also be able to maximize their income stream by increasing their equity exposure to dividend-paying stocks, which offer stable if not stellar returns and consistent dividends.

Many utilities are paying a 4 percent dividend, beating the 10-year Treasury yield of roughly 2.7 percent, Ely said.

Telecommunication stocks have also been a proxy for investment-grade corporate (not junk) bonds.

Despite the ability of dividend stocks to hedge inflation, investors should maintain an age-appropriate allocation, as they won't produce the returns needed to expand a portfolio.

And they should never be used in lieu of bonds, Woodham said.

"Dividend-payers tend to be less volatile than the broad equity market over time, but they still provide equity-like returns," Woodham said. "Substituting them for bonds will increase a portfolio's return and volatility over time."

Investors worried about their fixed-income investments should consider shifting into higher-quality, lower-duration debt instead of moving into 100-percent equity, she said.

In the context of bond alternatives, fixed-index annuities also bear mentioning—if only to urge caution.

Relative newcomers to the insurance world, these annuities combine the security of a guaranteed interest rate with the potential to earn more based on the performance of a designated index (typically the S&P 500).

When held in nonretirement accounts, they also offer the benefit of tax-deferred growth, but any gains are taxed as ordinary income.

And they have become popular. According to insurance and financial services association LIMRA, sales of fixed-index annuities reached a record $33.9 billion last year.

Yet the marketing can also mask the negatives.

For starters, upside potential is often limited to 4 percent or 5 percent per year, and investors are typically required to commit their money for 5 to 10 years or be hit with early-withdrawal penalties.

All considered, Freedman and Ely agree that fixed-index annuities are best used to protect against longevity risk (i.e., outliving your money) but inappropriate for use as an investment tool.

"Fixed-index annuities should not even be considered investments—we don't like the asset class," Ely said. "They are basically single-premium insurance policies, but a traditional fixed annuity [not fixed index] can be a good option for a very conservative piece of your portfolio."

With interest rates likely to rise, government-backed bonds are no longer the only port in the storm for investors seeking safety and yield.

Freedman said that those who defect to high-yield corporates, REITs, MLPs and dividend-paying stocks, however, should carefully consider the elevated risk and limit their exposure to maintain a diversification.

—Shelly Schwartz, Special to CNBC.com

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