By Pete Bush, CFP, Founding Partner, Horizon Wealth Management

With the so-called "credit crisis" reverberating through the financial markets, caution is the word of the day when it comes to building a portfolio for current income. The Fed has made successive rate cuts to help and there is talk of other remedies to come. So where do you go for income these days and what makes sense from a risk perspective in this market?

The natural inclination for nervous fixed income investors in this environment is to stay on the short end of the yield curve to minimize risk. With all of the uncertainty out there, it's natural to be a little skittish right now. However, by considering a couple of time-tested strategies, along with a couple of timely opportunities, you can build a fixed income portfolio that can be capable of weathering the storm.

First, consider buying bonds with more call protection. If the Fed cuts rates further, some of the best yields in your portfolio might get called away, leaving you scrambling for the best of the lower yielding alternatives then available to you at that time. In a stable or declining interest rate environment, extending the duration of your portfolio and likewise increasing your call protection can help insulate your portfolio's income until some higher yielding alternatives come your way.

It's Smart to Diversify

Secondly, it's just smart to diversify. Don't get too concentrated in any one issuer or sector, no matter how good the yields look today. Stock market investors have learned this lesson many times over the years, most recently when the tech bubble burst. Portfolios that were well diversified generally were better able to weather that storm, while those concentrated in technology issues and the now infamous internet mutual funds got killed.

Likewise, income investors that were over-weighted in mortgage backed issues while chasing the highest yields have been hurt by this latest crisis du jour. While it may be possible to make great gains by concentrating in one area, you may not be able to keep all of that gain unless you diversify. The market always seems to find a way to disappoint the largest number of investors. When it does, make sure you don't have your entire nest egg exposed.

With every bit of chaos, of course, there is opportunity. It's been said that the right time to buy stocks is when no one else wants them. That's usually the time when smart investors can scoop up some real values. What are people running from these days? Collateralized Mortgage Obligations (CMO's) and the financial sector, for starters. While the worst may not yet be priced into the market, keep an eye out for bargains in these two areas when no one wants to touch them with a 10-foot pole. Again, selection and quality are key items to consider.

Lastly, while many fixed income investors focus purely on the current yield, if you are willing to consider a total return strategy for a portion of your income allocation, check out some of the managed closed-end income funds. Normally, these baskets of closed-end funds trade at discounts to NAV of 3% to 4%. As of mid-December, we were seeing discounts of 2 to 3 times that normal spread. This creates the opportunity for capital gains if discounts move back closer to historical spreads the price moves back closer to the underlying NAV of the securities inside the closed-end fund. When you add that to the current yields in the ballpark of 7% to 8%, you just might be looking at a nice total return.

Tax Considerations

Managed portfolios of closed-end funds include both taxable and tax-free models. Picking the right model requires looking at your tax bracket to determine the best after-tax return. For those investors in higher income tax brackets, choosing a managed closed-end fund portfolio that invests in municipal bond issues can yield both capital gains and a steady flow of monthly tax-free income.

All of that being said, even during times of great uncertainty such as we are in right now, there are certain investing principles to which you should adhere to control your risk. Diversification is one of those. While you'll never have all of your eggs in the right basket at the right time, diversification will keep you from having all of your eggs in the wrong basket at the wrong time. Don't let the search for yield tilt your portfolio out of balance from a risk perspective. Your asset allocation still has to make sense, regardless of how much income you need for your portfolio to produce.

At the same time, when the market panics and there is chaos and uncertainty in certain sectors, it creates opportunities for those looking for value. When it does, consider investing for total return instead of just the yield, even for a portion of your fixed income allocation. You may just find that the gains could give you a greater nest egg to draw your future income from.

The views are those of Pete Bush and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Investments in securities involve risk. Principal, yield and/or share price will fluctuate with changes in market conditions and when sold or redeemed, you may receive more or less than originally invested.