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What to expect: Interest rates will climb another half a percentage point during the first six months of 1995.
What to do: Invest in short-term Treasuries and bank CDs and wait for an 8.5% plateau in long term rates that could signal it's time to change strategy. by Susan Scherreik
 The smartest way to invest for income in 1995 is also the safest: Put your money in one-to five-year U.S. Government securities and federally insured bank certificates of deposit. Normally, such investments pay paltry returns, but not these days. Yields on one-year Treasury bills have almost doubled in 12 months to 6.5% recently, while one-year CDs were paying as much as 6.3%. To boost your overall return to a comfortable 8%, add some slightly riskier investments -- like shares of utility companies or real estate investment trusts (REITs).
But watch for signs of an end to the steady climb of interest rates that has sliced nearly 30% off the price of a 30-year Treasury bond since February. Money Wall Street editor Michael Sivy predicts that long-term rates will rise from their recent 8.1% to about 8.5% by midyear and then level off. At that point, consider buying bonds with longer maturities. Reason: You will get the immediate benefit of higher yields and, if the Republican-controlled Congress manages to hold the line on inflation, you may even earn capital gains when long rates eventually decline.
That strategy, the consensus of a dozen investment pros and economists, should come as welcome relief for income investors, who were badly battered last year. Thanks mainly to the Federal Reserve's six straight hikes in short-term interest rates, bonds in '94 gave up 6.3%, their worst one-year loss ever. Seemingly safe short-term government bond funds that tried to boost yields by investing in risky derivatives fared nearly as badly, losing as much as 29%. One money-market fund even went under, handing shareholders a 6% loss -- the industry's first. And the damage is not over. The Fed may boost short-term rates by another half point before midyear.
 That's why, at least for now, the experts advise caution. "This year, it pays to stay short and safe," says Marilyn Cohen, head of fixed-income products at L&S Advisors, a Los Angeles money-management firm and one of the three investment advisers pictured on our cover. Fortunately, the pay is good -- a full 7.1% on two-year Treasury notes, which may be today's best deal among income investments. Yields on others are also tempting.
If you want to aim for a higher return, Wall Street strategists recommend putting 60% of your income portfolio in a combination of Treasuries and CDs with maturities of one to five years. Park another 20% in money funds, three- to six-month T-bills and ultrashort-term bond funds. Then divide the remaining 20% equally between beaten-down utility stocks and REITs, which offer a combination of yield plus appreciation that should push your overall return above 8%.
One investment notably absent from the list is tax-free municipal bonds. While muni yields notched up slightly at the end of I994, many munis were still paying less than the after-tax yield of taxable bonds for investors with taxable incomes below $250,000. the point at which the top 39.6% federal bracket kicks in.
Still, there are plenty of good choices -- which we summarize below in descending order of safety. (Yields, total returns and other details appear in the table on page 85.) And be assured that the money and bond funds we recommend don't dabble in risky derivatives.
U.S. Government Securities
Your Uncle Sam is paying more lor the use of your money than at any time since 1991. The recent yields on one- and five-year Treasuries (6.5% and 7.7%, respectively) were about one-fifth of a point higher than those of top-paying CDs. And since Treasury interest is exempt from state and local taxes, your tax-equivalent yield could be an additional half a percentage point higher in tax-heavy states such as California, Massachusetts or New York.
You can invest in Treasuries through bond funds, of course. But with $10,000 or more to invest, you would be better off buying individual bonds. Reason: Bond funds charge annual fees averaging 0.92% of total assets, and the value of their portfolios fluctuates with interest rates. If long-term rates climb by the predicted half-percentage point or so, for example, the share price of a fund with an average maturity of 7.5 years would fall about 2.5%, erasing roughly a third of its 8% yield. Individual bonds, on the other hand, can be held to maturity, thus sidestepping any principal loss. And by spreading your stake among issues with maturities ranging from three months to five years, a strategy called laddering, you ensure that you will always have at least some of your money coming back to you to reinvest if yields rise.
Certificates of Deposit
CDs are also paying their highest rates in three years, but you probably can't match the deals in our table at your local bank. So shop nationally for the best rate. Virtually all banks carry federal insurance on deposits of up to $100,000, and therefore your money will be as safe across the country as across town.
Two other shopping tips: Compare CDs based on their yields -- the actual percentage increase in your money over a year -- rather than their interest rates, which can be misleading. And steer clear of gimmicky products, like those that promise to step up your yield if interest rates rise; rarely do they offer the best payout, says Hugo H. Ottolenghi, editor of the newsletter "100 Highest Yields" ($124 a year: 800-327-7717).
Money-Market Funds
Now offering rates as high as 5.5% and likely to top 6.5% by midyear, these funds are attractive places to park cash while you wait for better investment opportunities. Most top performers, including OLDC Premium Plus and Benham Prime, have temporarily waived management fees to boost yields by half a point or so. But that may change. So far in 1994, some 34 funds have reinstated such fees, according to IBC/Donoghue. If your fund does so, move your stake elsewhere. Also, don't confuse true money funds with so-called money-market accounts at banks. The latter are federally insured (funds are not) but pay an average of only 2.6%, vs. the funds' 4.5%.
Ultra-Short-Term Bond Funds
For a slightly better yield with little added risk, check out funds like Strong Advantage and Pacifica Asset Preservation that invest in high-quality corporate and government debt with maturities of three to 12 months, vs. money funds' average of 42 days. Ultras' share value changes with interest rates, making them more volatile than money funds, where the share price is fixed at $1. But ultras were recently paying as much as 6.5%, about one percentage point more than the best money funds. And because ultras stick with very short-term debt, they can weather rising rates. In the first 10 months of 1994, for example, the average ultra returned an annualized 2.4%, vs. losses of 1.4%, 3.7% and 5.1%, respectively, for short-, intermediate- and long-term U.S. Government bond funds.
Utility Stocks and Funds
The shares of electric power companies suffered a double jolt in '94. Income-seeking investors deserted them for higher rates elsewhere. And individual companies got hammered by investors who feared the firms would be hurt by new federal rules that end the virtual monopoly they once enjoyed over customers. As a result, the Dow Jones utility average fell a staggering 25% in the 12 months to Nov. Its worst loss since 1974.
That sell-off has created some terrific bargains, says Barry Abramson of Prudential Securities in New York City. "Many investors panicked and dumped all their utilities, strong and weak alike," he says. Abramson and other analysts recommend that you buy stocks that meet these criteria: 1) a conservative dividend yield of 6% to 8%, since higher yields often indicate higher risk; 2) dividends that are growing at 3% a year, vs. the industry average of 1%; and 3) a payout ratio -- the percentage of earnings needed to meet dividends -- at or below the industry average of 80%. (You can get this information by calling the company.) Two utilities that measure up: New England Electric Systems (NES; NYSE, $29.75; 7.5% yield) and Southern Co. (SO; NYSE, $19.25; 6.1%). With expected price gains of 16% to 18%, both stocks could produce total returns -- price appreciation plus yield -- of 20% or better in '95. Or, if you prefer to let an expert pick your stocks, consider a top-rated utility or income fund like Stratton Monthly Dividend Shares or Fidelity Utilities.
Real Estate Investment Trusts
REITs, which often hold pools of commercial buildings, were a dicey investment during the late '80s and early '90s as real estate prices slumped. But now that real estate is reviving, REITs are coming back too -- with yields averaging 7.8% and the potential for double-digit returns.
When interest rates soared last year, the average REIT share lost 0.4%, vs. a gain of 19.7% the year before. Today, however, with the economy gathering steam, REIT analyst Barry Oxford of Alex. Brown & Sons in Baltimore expects top-quality REITs to produce total returns of 10% to 15% this year. Exceptional issues, such as Weingarten Realty Investors (WRI), which recently sold on the NYSE at a 52-week low of $34 with a 6.6% yield, could do even better. Oxford expects shares in the Houston company to top $47 by year-end '95. Because some newer REITs are of dubious quality, though, stick to issues that have 1) proven management teams that own at least 10% of the company; 2) total debt equivalent to 40% or less of their market capitalization, which is the number of shares times the share price; and 3) conservative 6% to 8% yields. Or invest in good REIT funds like Cohen & Steers Realty Shares or Fidelity Real Estate Investment.
Finally, as the year progresses, keep an eye out for a probable interest-rate peak. If long-term rates reach the predicted 8.5%, they will be five points above the expected 3.5% rate of inflation -- a much wider gap than the 3.8-point average spread of the past 17 years. So if rates seem to stabilize there, as Sivy predicts, then move the cash you've stashed in money funds into bonds or bond funds with maturities of 15 years or longer. That way, you'll earn a higher return and be in a position to profit if long rates come back down again.
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