It's a tough time to be an income investor. IBM just sold three-year bonds at the historically low yield of 1%, and other companies are selling bonds with yields at near historic lows. Meanwhile, Vanguard's Intermediate-Term Investment Grade Corporate Bond fund is yielding 4.7%. This fund targets a dollar-weighted average maturity of five to 10 years.

Yield-hungry investors are pouring money into master limited partnerships (MLPs), which boast substantial yields but also carry substantial risk. Kinder Morgan, a large MLP, is yielding 6.3% as of this writing. Enterprise Products Partners, another large MLP, is yielding 6%.

A range of stocks currently provide high dividends, but investors remain gun-shy about equities. Con Ed, which just sold 10-year bonds with a yield of 4%, has a dividend yield of 4.9%.

Corporate bonds that are below investment grade are also providing high yields. BlackRock Corporate High Yield Fund has a yield of 8.7%, and Vanguard High-Yield Corporate fund is yielding 7.6%.

How can income investors make sense of these alternatives? This article provides a new approach to evaluating the relative attractiveness of income-generating assets, as well as a series of pitfalls to avoid.

YIELD VS. RISK

Articles on bonds and other income asset classes tend to focus on yield, but they pay scant attention to quantifying risk. We know that the variability in yields on bonds and bond funds reflect differences in maturity and credit quality, but how do we consistently judge the relative attractiveness of our choices? How do we decide whether to buy Con Ed's stock and get a 4.9% yield or to buy the 10-year bond with a yield of 4%?

With the emergence and maturation of exchange-traded funds (ETFs), it is now possible to create a new benchmark for comparing risk-adjusted yields on various alternatives. There are listed call and put options on many ETFs. We can use the prices of options to infer the market's consensus view of the risk of these ETFs.

The measure of risk derived from options prices is called implied volatility. You can get implied volatilities from www.ivolatility.com or from Morningstar's option analytics. Volatility is a measure of risk, and numerous studies have found that implied volatility is the best estimate of future volatility that is available.

The availability of implied volatility data provides us with a way to judge the yield of individual investments and of portfolios as a whole. The chart in "A New Yield Comparison," on page 170, shows yield vs. implied volatility for a series of ETFs, MLPs and individual stocks.

I used options with expiration dates in early 2011 (ranging from January to March) because this was the longest time horizon for which some of these stocks and funds have listed options. It would be preferable if there were longer-dated options, but we can work with what we have.

The chart provides an entirely new way to compare the yields of various investment alternatives. As we would expect, intermediate-term government bonds are riskier and have higher yields than short-term government bonds. Long-term government bonds are riskier and have higher yields than intermediate-term government bonds. Also as we would expect, high-yield bonds are riskier and have higher yields than investment-grade bonds. These are the common-sense results that provide some faith that our approach makes sense.

Aside from the relationships that theory would predict, there are a range of other useful pieces of information here. First, government bonds do not look attractive on the basis of this measure. Con Ed's stock, for example, has similar risk but substantially higher yield than long-term government bonds. The really striking result is that high-yield corporate bonds have dramatically higher yields than long-term government bonds, with about the same level of risk. Similarly, investment-grade corporate bonds provide more yield with less risk than intermediate-term government bonds.

The two MLPs on our chart, Kinder Morgan and Enterprise Products, look reasonable in terms of yield vs. risk, but they are not terribly attractive. REITs look incredibly unattractive on the basis of yield vs. risk.

Examined in this fairly simple and intuitive way, it would appear that corporate bonds are the most attractive way to get the highest level of return for a risk. Long-term government bonds look like the least attractive fixed-income class.

It is important to understand, however, that similar expected levels of total risk (via implied volatility) do not mean that the risks are totally comparable. The risk associated with government bonds is different than the risk associated with individual securities or corporate bonds. The major risk for government bonds-and this is highest for long government bonds-is a rise in interest rates. The risk with high-yield bonds is principally default risk. The risk with individual securities is largely company-specific risk. Buyers of long-term government bonds are implicitly betting against an increase in interest rates. High-yield bonds, by comparison, are relatively neutral with respect to interest rates.