With interest rates low worldwide, here are seven strategies to amplify the yield on your investments — with the risks and rewards of each.

The global financial crisis has forced interest rates close to zero on conservative investments like Treasury bonds as governments worldwide have moved aggressively to make credit more widely available.

But investors have other options in their hunt for a cushion against the bumps in the stock market.

Fixed-income investments other than Treasury bonds “today offer the best relative value in the market,” said Ford O’Neil, manager of Fidelity’s Total Bond Fund (FTBFX) with $9.7 billion in assets. “They’re the cheapest they’ve been in the past 25 years.”

The alternatives, all available through mutual funds, offer yields of up to 15% or so — compared to about 3.5% for a 10-year Treasury note. The opportunities are many, and the options vary depending on your risk tolerance. Some are definitely not for the faint-hearted.

“It’s important for investors to know the risks of the investments they’re making,” said Gibson Smith, co-chief investment officer at Denver mutual fund company Janus Capital Group.

Some of the investments that fall on the safer side include municipal and investment-grade corporate bond funds, as well as balanced funds that hold stocks and bonds. Moving up the risk ladder: Funds holding preferred stock; real estate investment trusts; and junk bonds and junk bond funds.

Income-producing securities may be more conservative investments than stocks, but they aren’t a sure bet. Accelerating inflation can erode the value of bond yields. Moreover, if the economy weakens further, there could be a jump in the number of companies defaulting on bond payments.

Experts advise a diverse investment mix. “It’s important for investors to figure out a yield mixture that represents a balance of different securities between ultra-risky and ultra-safe,” said Wes Moss, chief investment strategist at Capital Investment Advisors, a fee-only advisory firm in Atlanta.

“You want to think about the risk-reward trade-offs,” said Fidelity’s O’Neil.

Here are seven strategies for capturing higher yield, with an assessment of the potential risks and rewards for each category.

Municipal bond funds: These funds offer modest yields but also low risk and no taxes — making after-tax returns much more appealing for many investors. There is some risk that the cities, states and municipalities issuing the bonds to pay for roads, schools and other projects will default on their payments, but that risk is generally quite low. On the other hand, some states, notably California, are in serious financial straits. This means investors should tread extra carefully in this arena.

On the plus side, the income investors get typically is tax free, although not all municipal bonds are exempt from federal and state taxes.

“The yields aren’t fantastic. But they’re certainly better than Treasurys,” said Moss of Capital Investment Advisors, noting it’s relatively easy to find a municipal bond fund yielding 4% or more — a yield that’s north of 5% when you factor in the bonds’ tax-free status. On a tax-equivalent basis, that’s roughly 1.5 percentage points above the yield on a 10-year Treasury note. Yields for typical municipal bond funds range from 2.25% for short-term, high-quality funds to more than 6% for funds that invest in riskier securities.

Investment-grade corporate bond funds: These provide a relatively high yield with limited risk that the issuer will default. But if the economy sinks further or a big financial company goes bust, credit could evaporate and corporate bond defaults could indeed jump.

“We think it’s a good time for pretty high-quality corporate bonds,” said Todd Burchett, manager of ICON Bond Fund at ICON Advisers, a mutual fund company in Greenwood Village, Colo.  Yields on investment-grade corporate bond funds range from about 5% to 8%.

Balanced funds: These funds, which typically invest in a mix of stocks and bonds, offer some of the potential return of stocks with some of the stability of bonds. One risk is that companies can cut dividends — more than 60 have this year, according to Standard & Poor’s. Also, Uncle Sam can boost taxes on stock dividends. Those are risks because these funds often invest in stocks with what look like solid dividend yields. In addition, there also are the normal risks of investing in stocks and bonds.

“I would suggest people look at a mixture of large-cap, U.S.-based dividend-paying stocks — especially those that sell into international markets — and high-quality corporate bonds,” said James Swanson, chief investment strategist at MFS Investment Management in Boston. Simple balanced stock-bond funds offer yields ranging from about 2% to 5%.

Convertible bond funds: Considered “cheap” by some investors, these funds offer the relative safety of corporate bonds plus the upside potential of stocks. Convertible bonds allow holders to convert their bonds into stock, and if they do, prices can fall.

“If the company does really well, you have the option of converting some of those bonds into common stock,” said Swanson, adding convertibles “right now are cheap,” with convertible bond funds yielding anywhere from 4% to 10%.

Preferred stock funds: These funds can throw off generous yields but also can get stung if the companies held in the fund go bust. Preferred stock has characteristics of both a stock and a bond: It pays a set dividend, and that payment takes priority over dividends to holders of common stock.

A note of caution: Expect volatility, and hope issuers don’t go belly-up. “You’re second in line behind the bondholders and secured lenders in the event of a default,” said Burchett of ICON Advisers. Yields on preferred stock funds range from about 7% to 12%.

Real estate investment trusts: Also considered inexpensive by some investors, these can offer a relatively high rate of return. But REITs also can be volatile since they are essentially real estate companies selling stock in themselves. REITs typically manage income-producing properties such as office buildings. Investors get shares and a quarterly payment representing a REIT’s income. You can invest directly or through a REIT mutual fund.

“People should at least begin to look at these as they tend to recover later in an economic cycle,” said Swanson at MFS.

Just how volatile can REITs be? One key index tracking this investment class — the MSCI U.S. REIT index — is off about 16 % so far this year.

Junk bond funds: Junk bonds offer high yield, along with a high risk the company issuing the bond will go broke. Junk bonds aren’t investment grade and are subject to big price swings. “They tend to act more like equities than bonds,” said Clint Edgington, president of Beacon Hill Investment Advisory, a fee-only investment advisory firm in Columbus, Ohio. One good option is a high-yield bond fund: A pro picks the bonds, and the holdings are diverse.

Experts advise investors to stay away from buying individual junk bonds. “I would argue that would be very risky,” said Fidelity’s O’Neil. He and others said that a junk bond mutual fund is a better option. Such funds currently offer yields ranging from roughly 8% to 13%.

So take your pick. But remember that while these alternatives can boost the yield on your investments, they don’t offer the safety of government Treasury bonds or other Treasury securities.

How much of your portfolio should be in these types of assets? That depends on your age, risk tolerance, overall mix and other factors. Your financial adviser or Fidelity’s asset allocation tool can help.

BY ROGER FILLION, FIDELITY INTERACTIVE CONTENT SERVICES

Investors looking for yield right now are having a tough time of it.

What are your options?

Short-term savings rates are desperately low. The government is keeping official interest rates low to help stimulate the economy, and that feeds through to your bank or money market account. You can get 2.4% on a one-year certificate of deposit, according to Bankrate. But you are probably better off avoiding long-term lock-ins, and waiting for better opportunities.

Ten-year Treasurys yield about 3.8%, after briefly touching 4% this week. That’s a lot better than a few months ago, but don’t be fooled: It’s still a gamble that inflation will stay low. You should really only buy these bonds if you are confident annual inflation will average less than 2% a year for the next 10 years (Otherwise, if you had to buy a ten-year Treasury bond, you’d buy the inflation-protected ones, known as TIPS, and lock in 1.9% plus the inflation rate.) If consumer prices surge, and they very well might, conventional Treasurys will fall in price and lose value in real terms.

Municipals may be bit more attractive than nominal Treasurys, especially for higher-rate income taxpayers. An exchange-traded fund like the SPDR Barclays Capital Municipal Bond fund (TFI) is yielding 3.84%, tax free. But you also have an inflation problem. Most of the fat yield comes from longer-term bonds, also at risk from rising prices.

Some municipals are slightly better. But anyone locking in long-term rates by purchasing a bond is taking a gamble that inflation will stay subdued. If it surges instead and rates climb, the bond will fall in price and the income from its coupon will lose buying power.

There are still opportunities in corporate bonds, where some yields still look attractive. Ten-year single-A corporate bonds, which are at the riskier end of investment grade, still yield about 6.8% on average. But you have to be selective, balancing the risks of default and inflation. A veteran fund like Loomis Sayles Bond (LSBDX), with a recent yield of 7.75%, is usually the low-stress way to do it.

Don’t overlook the stock market. There are terrific shares out there with dividend yields beating 4%. There are opportunities in telecoms, oil and energy, pharmaceuticals, consumer staples and utilities. Among them: AT&T (T) yields 6.8%, London-based global mobile giant Vodafone(VOD), Pfizer (PFE) 4.3%, Merck (MRK) 6%, American Electric Power (AEP) 6.1%, Kimberly-Clark (KMB) 4.5%, Kraft (KFT) 4.4%. Other notables include Intel (INTC), yielding 3.4%, and London-based Diageo (DEO), maker of Smirnoff, Guinness and plenty of Scotch whisky, yielding 4.0%.

Obviously share prices are volatile — you hardly need to be reminded of this, after the past 12 months — and no dividends are guaranteed. They can be cut if profits are squeezed. On the other hand, they can also rise — and you would expect that to happen if the economy, and inflation, picks up. If you don’t want to pick individual stocks, but want a basket of them, funds that invest in shares with high dividend yields include Vanguard High Dividend Yield Index(VHDYX), and Eaton Vance Tax Advantaged Dividend Fund (EVT), a closed-end fund you buy like a share.

With a sharp fall in interest rates in recent months, life for savers has become much tougher. Bank fixed deposits are offering as low as 3.5-5.5% returns for 6-12-month  period and liquid schemes of mutual funds just a little higher at 4-6%. In other words, holding cash or short-term deposits has started to pinch. 
The market situation encourages even risk-averse investors to step up their risk appetite marginally in order to take advantage of higher returns. One such opportunity where the market is offering an attractive risk premium for investments is that of “income funds” offered by mutual funds. 

Many investors who have significant investible surpluses appear not to be convinced of the opportunity to invest in income funds. Most investors who do not relate to volatility in debt markets are quite comfortable with the same in equities. 

Investors in income funds must be prepared to stay invested for a minimum period of six months, if not a year, and evaluate the returns on their investments for the holding period and not on a day-to-day basis. In fact, according to Crisil Composite Bond Fund index, those who invested in these funds earned handsome returns (please note that past performance is not indicative of future returns). 

The Crisil benchmark for the period ending April 29, 2009 went up by 20.1% p.a. in six months and 10.4% p.a. in 12 months (Source: mutualfundsindia.com). Investors need to appreciate that these returns were achieved not in a straight line, but despite a significant volatility in the benchmark 10-year government bond yields. 

Another important point to consider here is that like in any volatile asset class, the returns in income or bond funds vary considerably from fund to fund. It is here that the expertise of the fund managers is tested. This brings us to understanding an important difference between “actively v/s passively managed income funds”. 

Passively-managed income funds, by definition, mirror the benchmark index whereas actively-managed funds aim at outperforming the index. Those fund managers who have actively or dynamically managed their funds well have been able to outperform the benchmark considerably. 

The case for investing in income funds is stronger at this time since the 10-year government bond yields have not fallen in line with a sharp decline in short-term rates. The spread between yields on 91-day Treasury bills and 10-year GoI bonds has gone up from 60 basis points to 290 basis points and that on the 364-day Treasury bills has gone up from 40 basis points to 250 basis points over the one-year period ending April 29, 2009. 

This disconnect is due to the overhang of government borrowing programme for FY09-10, which is high considering the high fiscal deficit. The market is looking for more reassurance on factors such as how RBI is managing the borrowing process for the government — whether there are any policy decisions by the new government relating to disinvestments and so on that can reduce this high deficit. 

There is a good possibility that the current spreads between short-term yields and 10-year yields could contract as a result of a fall in the latter. However, over a medium-term, the policies of the new government will determine the bond yields. 

A key differentiator between gilt funds and income funds is that the latter maintain an appropriate blend of corporate credits and government securities. This blend provides the benefit of diversification, particularly when the credit spreads are contracting. 

Over the past one year, the credit spread between 10-year AAA-rated credit and 10-year GoI bond went up from 200 basis points to almost 400 in October 2008 and has come back to 200 at the end of April 2009 (Source: Bloomberg). The concerns on many AAA credits have abated and it is likely that this spread will come down further. It should be noted that the credit spread had gone to as low as 25-30 bps in mid-2005 when the credit appetite was at its best. 

Investors who invest in carefully-selected dynamically-managed income funds should aim at taking advantage of an attractive risk premium offered by such funds when compared to bank fixed deposits /liquid funds. Investors must take the help of investment advisors in selecting appropriate dynamic income funds and each investment decision must follow an assessment of the individual’s risk profile. 

By Nikhil Johri of The Economic Times