By Chris Boyd

It's become more challenging for retirees seeking income. Last year, as investors became more aware of the challenges rising interest rates can have on bond investments, some may have been moving toward an overweight in dividend paying stocks, like utilities, telecoms, and the like. For a time, these kinds of stocks saw an attractive return, as yields provided solid income, and because of the increased demand for income, prices rose nicely.

This year, many solid dividend stock sectors have seen declines, in part because of having risen to lofty valuations. Drifting from traditionally low risk-investments such as bonds toward dividend paying stock sectors is still a move from bonds to stocks. That means an increased possibility of volatility. We generally don't mind that increased volatility when it means prices are rising, but many income investors want less risk. Stocks, even ones with nice dividends, involve an increased range of movement and the possibilities for more substantial declines.

To include various investments in part in a portfolio can have virtue, but there can be too much of a good thing. It is common for investors to chase yield and unknowingly increase the risk of their portfolio by gravitating toward high-yield bonds. These are bonds with more credit risk.

In a diversified fund, these can be an appropriate component of a fixed-income portfolio, but prices of these investments are often driven by the same forces that move stocks, In other words, high yield bonds are more correlated to stocks, and although they experience less significant declines than stocks generally, they are likely to decline in price when stocks go down, too.

For most investors, we want at least some bonds to be a buffer to stocks' volatility; that's at least part of the reason we own them. So, don't get too much of a good thing when thinking about high yield bonds.

Other income investments that can be attractive as a component of an income investment portfolio, but have risks more akin to equities than bonds are real estate investment trusts (REITs) and master limited partnerships (MLPs). REITs can be those that trade on exchanges, or those that are considered illiquid.

For most retirees, illiquid investments should be avoided or at least kept to a minimum. Why have the extended delay to get access to these assets, when there are plenty of other choices that trade on an exchange?

For those interested in these holdings, look to diversified bundles of REITs, like the Vanguard REIT ETF (VNQ) or a managed mutual fund offering like Cohen & Steers Real Estate Securities Fund (CSDIX).

Even so, in a rising interest rate environment, risks may be increasing in this arena. As interest rates rise, the alternative choices with less risk may become more attractive. REITs as a category have been a winner for the past decade, with solid income and relatively modest risks, but in the rising-interest-rate environment, tides may be changing. Should there be an eventual recession, investors should consider reducing these investments.

MLPs, effectively a subset of energy stocks, have been an income-generating powerhouse over much of the past decade. Fluctuations in energy costs have had an impact on the profitability of these toll-road pipelines. With changes in recent tax law, and again the fact that these are essentially another manner of equity, investors should not underestimate the risks here.

Frequently, we think of the Barclays US Aggregate Bond Index as representative of what happens to bonds and thus bond for investors. It's worth recognizing that this is not necessarily the way bond investors might always want to invest. Although there is certainly some merit to the low-cost investing represented in passive index investing, in the area of bond investing in the setting of a rising interest rate environment, it's wise to consider some alternative approaches.

In the bond index, better than half the index composition is U.S. Treasuries and Agency Mortgage Backed Securities, which are more sensitive to interest rate risk. One of the reasons investors generally prefer indexing to management is cost. Fortunately, bond fund managers tend to be more cost conscious than equity managers. In the case of bonds, the modest extra cost of management can certainly add value. The process of screening out companies that are part of the universe of investments in an index by the fund manager's research can add value materially.

Investors have heard that rising interest rates can cause existing bonds to become less valuable. As interest rates or yields rise, existing bonds decline in price. It becomes important to compose a mix of bonds that won't decline too much when interest rates rise. The measure of duration is what people look to as an indication of interest-rate risk.

Because we've been concerned about the prospects of rising interest rates, at our firm, for most investors we've chosen a design that we think is suited to hold up relatively well in a rising-interest-rate environment. What we've done is to break our bond investments approximately equally into three categories: short-term, intermediate term, and bond investments with other risks, primarily credit risk.

For short-term bonds, we like to pair USAA Short Term Bond Fund (USSBX), which is a very cautious low risk design, in the one- to three-year bond space, with Thompson Bond (THOPX). Although the returns USSBX are modest, this fund doesn't cause any loss of sleep (of course, "past performance is not necessarily indicative of future returns"). Thompson moves within the investment grade bonds arena (from AAA to BBB). When spreads justify taking the greater risk of BBB bonds, they move toward that lower rate investment space, otherwise, they move up the risk spectrum, but always buying bonds of investment grade. Think of them as a "value investors" in bonds. If they perceive the price of the BBB bonds to be sufficiently discounted, in effect, then they go shopping because they expect the price to eventually rise while also collecting a more attractive income. That said, we recognize that this fund has more risk than its partner.

There are numerous quality funds out there in the Intermediate term space. Again, we prefer not to make use of the aggregate bond index in a rising-interest-rate setting, but there are corporate bond funds that fit this space. As mentioned before, in the world of bonds, selection and research is worth some cost. There are many quality managers in this space. Although there are plenty other worthy of consideration, we like Dodge & Cox Income (DODIX), Metropolitan West Total Return (MWTRX), and DoubleLine Total Return (DLTNX). Although these are all funds in the same space, each approaches things differently.

For larger portfolio investors, it is also reasonable to use a laddered bond portfolio comprising corporate bonds instead of funds in the short- and intermediate-term bond categories. This can be done by staggering maturities over years (i.e., 6 to 8 years). The virtue of this approach is that you can control your response to interest-rate risk, knowing that bond prices will rise back to par as they move toward maturity. This can make it easier to understand and endure the inevitable interest rate risk. A common challenge here is not simply the limited research abilities of individual investors compared with institutional investors, but also the importance of striving for sector diversification.

In the final area of the bond portfolio construction, do include some credit risk.

As mentioned before, within reason, high-yield bonds can be attractive and enhance a portfolio with greater income, despite the increased volatility potential. Here, too, there are an abundance of quality funds available, but there is risk. Lord Abbott High Yield (LHYAX) is our preference.

Depending on how far into the credit risk space you are willing to go can impact which managers you might select. Some will at times go heavily toward CCC-rated bonds. Because of the nature of our clientele being primarily retirees, we wanted a team that had limitations in place to prevent drifting that might inadvertently increase risks beyond our comforts.

Vanguard High Yield (VWEHX) and PIMCO High Yield (PHIYX) are both funds that have historically been hesitant to go too deep the junk space. This is certainly a space where investors should favor use of a manager over use of an index. As much as ETFs have many virtues, investors should avoid unmanaged ETF indexes in this space as these funds will own the universe of higher credit risk holdings. Better to have a manager in the mix to screen out some of those choices that are predictably problematic.

Within this one-third of the bond fund selections, use of a floating rate or bank loan fund can be worthy of consideration. We favor choices that have less credit risk, like Fidelity Adv Floating Rate Fund (FFRAX) or its no-load equivalent (FFRHX). In this space, not all funds are alike in their risks. Some will have more credit risk. The beauty of these funds is that they have virtually no interest rate risk, as the fund's yield will ultimately increase as interest rates rise, but they do have credit risk. Finally, in this credit risk area, we also include a strategic income fund that can go anywhere, PIMCO Income Fund (PONAX). This manager has been impressively adept at navigating differing risks and environments.

Although this three-part structure I've described is well designed for a rising-interest-rate environment, it will require a readiness for tactical changes.

As we move toward the later part of the economic cycle, planning for the prospects of an interest rate environment where the Fed drives down rates is foreseeable within the next couple of years, so plan ahead for what's on the horizon. Getting help from a quality financial adviser is always recommended. Read these guides to finding the financial adviser for you, from the Financial Planning Association and from the Certified Financial Planner Board.

About the author: J. Christopher Boyd, CFP®, CASL®, is the founder of Asset Management Resources and the chief investment officer. He has been assisting clients on Cape Cod for two decades. His firm Asset Management Resources, LLC is a registered investment adviser firm in Massachusetts. He is the 2018 president of the Massachusetts Chapter of the Financial Planning Association and also a member of the Estate Planning Council of Cape Cod.