Last week we highlighted a contrarian value opportunity in real estate. This week we ll take a look at a few beaten-down income funds, namely a few that primarily own bonds and preferred stocks.

Not since the end of the 2002 bear market in equities has there been such a concerted interest in income investing. Like investment banks and real estate developers, retirees and near-retirees, many of them bruised from the disastrous stock market, are reining in their taste for volatility and risk. With savings yields meager and the world economy weak, more investors are pursuing an approach that stresses preservation of capital and regular income over capital gains.

Yet it s a downright difficult time to be an income investor because, as 2008 demonstrated, even highly-rated corporate or municipal bonds can rack up equity-sized losses. Moreover, the supposed benefit of diversifying with bonds doesn t always work either. Last year bonds and corporate credits of every stripe fell sharply, with Treasurys the only subsector actually getting a bid.

As I wrote last week, I m by nature not a value player. Markets down sharply from previous highs tend to need a refraction period in which to attract a new audience of owners. The value investment we often think of as a bargain can stay a bargain for longer than most of us might ever imagine. The advantage with income securities is, of course, that at least you re getting paid while you wait for conditions and credit spreads to improve.

When searching for income-oriented investments, too often investors look over a list of possible options and buy the one with the highest dividend, assuming that, at worst, they ll get the income. What they too often fail to acknowledge is that the dividend payment, regardless of how generous, doesn t mean much if the underlying security falls sharply in price. This was certainly the case with REITs, energy-trusts, floating-rate bonds and dividend stocks in 2008. You made your 6% dividend but the stock itself lost 35%. This is why the same technically-minded approach we use in stock selection should be considered for income investing as well. Better to choose a stronger investment with a lower payout than a weaker alternative with a higher yield.

In recent weeks, corporate bonds, including low-rated junk bonds, have rallied sharply as markets have regained a taste for lower-rated debt. Given all the government intervention, bailouts and stimulus, it s difficult to know which moves to discount and which to trust. For those investors searching for higher yields, there are a number of closed-end funds offering encouraging price action as well as large payouts. All should be seen as one part of a larger portfolio.

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holds 45% in mortgage-backed securities, along with a broad exposure in foreign, asset-backed and corporate credits. The fund s top holding is a Japanese government bond, which has helped the fund as the yen has rallied, with roughly 20% of its assets in foreign holdings. Before 2008 s 34% decline, PIM had posted gains for nine straight years. At a recent $4.42 per share, it yields 12.3%, payable monthly.

Putnam Master Intermediate Income Trust (PIM)


Putnam Master Intermediate Income Trust

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DWS Multi-Market Income Trust (KMM)

In 2005 and 2006, investors become enamored with emerging markets, piling into Brazil, Russia and other far-flung corners of the globe that offered the prospect of high yields and even higher growth. That trend sharply reversed as commodity prices began to drop, prompting a record $48 billion outflow from emerging-market funds, according to research outfit EPFR Global.

While technically a high-yield fund, KMM s current allocation is decidedly foreign, with only 51% exposure to the U.S. and extensive holdings in the sovereign debt of Brazil, Peru, South Africa and Mexico. Value investors will appreciate the fact that they're buying a bargain, as the fund is trading at a 13.45% discount to its underlying net asset value. Dividends are paid monthly, with a current yield of 11.60%.

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holds 78% of its assets in domestic high-yielding junk bonds, the BBB, B and CCC rated credits of highly risky and leveraged companies that are most susceptible to the credit crisis and stagnant economy. That poor backdrop explains the fund s 2008 performance, a peak-to-trough drop of more than 61%. As an asset class, junk bonds had their worst year on record.

MFS Special Value Trust (MFV)


MFS Special Value Trust

So far in 2009, there's plenty of evidence that the appetite for low-rated bonds is on the rise. Corporate-bond spreads are now at their tightest levels since October, and investors are once again funneling money into junk-bond funds. MFV is trading at record 15% discount to net asset value, while in better economic times it traded with as much as a 20% premium. At a recent $4.38, the fund offers monthly payouts with a yield near 11.5%.

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Preferred stocks, long a favorite option for investors searching for income, were crushed in 2008, perfectly demonstrating how even an attractive yield can t compensate for weak price action. Many preferred funds hold primarily bank shares, which contributed to hefty losses even among conservatively managed funds.

Nuveen Quality Preferred Income Fund 2 (JPS)

Nuveen Quality Preferred Income Fund 2 holds 32% of its assets in those very bank preferreds, including issuers such as Wachovia, ING Groep NV (ING), Banco Santander SA (STD) and Deutsche Bank AG (DB) . The fund is trading with an attractive dividend yield of 14%, and despite a recent rally is still down some 40% from levels seen last fall.

Preferred stocks are stocks, and will tend to rally and fall along with the market s overall appetite for risk. But income investors looking for ideas to populate a portfolio of dividend-paying stocks might find JPS an ideal addition. As with any investment, risk control is a must, which is why with all of these funds I d advocate a stop back near the December lows.