Too often, in a high-flying economy driven by powerful asset bubbles, the siren song of big risks for big returns is too powerful to ignore. Many retirement-age individuals who invested for "go-go" growth have paid a painful price. Their portfolios have diminished to such a large degree that their retirement dates must be pushed back.

Many now face the difficult decision to cut spending or dip heavily into portfolio principal to cover expenses. While the impulse for these retirement-age individuals may be to stay fully invested in all growth areas to try to make their money back, they are missing the important lesson of appropriate asset allocation and the ways an income-oriented portfolio can protect and grow their hard-earned savings.

But retirement-age clients need not resign themselves to a portfolio of Treasury bonds with pitifully low yields. Investing for income can offer opportunities for principal appreciation too, and a diversified portfolio of income investments can deliver a current income stream in today's marketplace of anywhere between 5% and 7%. Though perhaps without the same long-term upside potential of growth investments, income investments typically provide a lot less interim volatility.

In other words, it may be OK to sleep at night again after the market crash of 2008.

Beyond Laddered Bonds
Smart income portfolio investing encompasses more than just building a static ladder of bonds. Active management principles should be applied to an income-oriented portfolio as they would be to a growth portfolio. For fixed-income investments, active managers must manage the yield curve, watch sector rotation and monitor dislocations within the often inefficient credit markets for opportunities.

This last point has never been more important given the turmoil within the credit markets in 2008. As investor fears ran high last year, just about all fixed-income sectors with the exception of Treasury bonds came under pressure, often without cause. As cooler heads prevailed with the turn of the New Year, bonds have staged a significant rally so far this year and credit spreads have begun to tighten.

However, risk premiums are still generous by historical standards for many high-quality bond investments. For example, corporate bonds in the bank and finance sector still have high yields, while industrial credit spreads have narrowed significantly and may be too rich for their credit fundamentals. Callable and step-up coupon agencies are also compelling options, offering comparatively better yields than more traditional bullet agency structures. Certain sectors of the mortgage-backed and asset-backed securities markets are showing signs of improvement, too, especially as the liquidity benefits of the Federal Reserve Term Asset Lending Facility (TALF) and the Treasury Department's Public-Private Investment Program (PPIP) take effect.

Municipal bonds offer pockets of value as well, especially in revenue-backed sectors that investors have shunned, in some cases for the perceived safety of general obligation bonds. Some of the latter bonds, meanwhile, also offer a significant yield premium. But investors in those general obligation bonds must be willing to take certain risks-for example, wagering that the state of California is not going to default on its debt, despite its well-publicized budget deficits. It is important to keep in mind, meanwhile, that many high-quality corporate bonds are yielding more than municipal bonds on an after-tax basis, presenting an arbitrage opportunity-at least in the short-term-for the active fixed-income investor.

Even after a robust start in 2009, in which most high-yield bond funds were up by more than 25% as of September 1, the junk bond market still offers value with yields above 10%. While defaults in this space will clearly be higher in the future than they have averaged recently, yields this high are enough to compensate investors to take the risk. Many high-yield bond managers anticipate another 300 to 400 basis points of spread tightening before the year is done, meaning there is still room for a significant total return from both principal and income.

Earning With Equities
Beyond bonds, an income-oriented portfolio may include allocations to high-dividend paying equities, real-estate investment trusts (REITs), preferred stocks and master limited partnerships (MLPs). These instruments offer the upside potential of equity markets but with the juice of an income stream to enhance returns, income that in some cases limits the downside risk during a market correction. However, these equity investments are not without risk themselves and can experience painful downdrafts, so it's necessary to make sure the allocations within the income portfolio are appropriate for the investor's time horizon, liquidity needs and risk profile.

Market statistics will show that high-dividend-paying stocks have outperformed non-dividend-paying stocks (with lower volatility) over the long term. They tend to outperform during bear markets, and in a recession their stock prices depend less on earnings. But equity income investing is not just about picking those stocks with the highest dividend yields of their peers. A company must also have a track record of dividend hikes, a payout ratio below 50% (as a more moderate dividend is less likely to be cut), reliable management and growing earnings.

There can be some slack allowed on these earnings during a recession, but not much. Especially now, investor due diligence is critical at a time when many dividends are at risk as companies hoard cash in a competitive landscape. A time when companies with historically safe dividends like General Electric have done the unthinkable and cut their payouts to shore up balance sheets. Given those circumstances, high dividend stocks should not be purchased with a buy-and-hold mentality, but actively monitored for changes in the company's management strategy and financial position.

REIT investments must also be carefully monitored, especially in light of recent IRS changes to their income distribution requirements. REITs, whose structures require them to distribute 90% of their pretax income to investors, are now allowed to do so by issuing stock to supplement or replace cash payments, according to a recent IRS rule change in effect at least through 2009. Since cash dividends have historically accounted for about 65% of total equity REIT returns, these new stock dividends are a concern. They raise transaction costs and increase the risk that a holder will have to sell them at an inopportune time.

Yet even with that risk, REIT yield spreads are currently still more than 260 basis points, well above the long-term average of 118 basis points. If the housing markets stabilize, if REITs can continue to tap the capital markets, and if, because of that capital access, they can avoid paying stock as dividends, then these instruments could still be an attractive addition to an income portfolio.

Meanwhile, preferred stock investments, senior to common equity in the capital structure, offer attractive yields averaging between 8% and 12%, though a company could skip or defer dividend payments under the terms of most structures. Yields are still very high in this space given investors' fear and confusion after the apparent wipeout of preferred-stock holders in companies such as Lehman Brothers, Fannie Mae and Freddie Mac. As they do in corporate bonds, financials offer the best value within the preferred landscape right now-no surprise given the obvious risks.

Finally, MLPs, publicly traded energy partnerships that are registered with the SEC and trade on major exchanges, offer an opportunity to maximize income because they are required to return all profits to unit holders. Since most MLPs operate oil and gas infrastructure such as pipelines, processing plants and storage tanks, they are also attractive as investments in the underlying hard assets owned by the MLPs. The valuations of MLPs imploded during the 2008 market crisis, primarily because of their loan and hedging exposures to large investment banks like Lehman Brothers.

Even after strong performance this year, however, the valuations are still at reasonable levels. MLPs also have tax advantages, as taxes are assessed only on a fraction of the income paid out during the holding period, with the rest of the tax liability incurred at disposition. Because of that, MLPs are not generally good investments for tax-sheltered portfolios such as IRAs, since they can create unrelated business income tax (UBIT) exposure for investors. Also, it is important to note that MLPs, as partnerships, issue Schedule K-1 tax forms in March, so they can delay tax filings. The delays are perhaps worth having, though, considering the possible capital appreciation and the yields, which were between 8% and 10% as of September 1.

The Specter Of Inflation
Despite these advantages, income-oriented securities are not without risk. In 2008, some of them saw market value losses akin to those in traditional growth investments because they were concentrated in high-risk sectors like real estate, financials and energy.

But perhaps the greatest long-term risks to an income-oriented investor are rising interest rates and inflation, which erode the relative value of the income stream. As much as the Fed insists monetary policy will remain accommodative for the foreseeable future, upward pressure on interest rates will likely continue, especially in light of the growing federal deficit and accompanying inflation fears. As Ronald Reagan said in 1978, "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." Especially for income portfolios, active management is key to reducing this impact of inflation and protecting principal and income over the long term.