Investing isn't just about buying assets that will go up in value; it's also about buying assets that can produce income along the way. 

A proper portfolio generate steady income regardless of the path for interest rates and the ups and downs on Wall Street. In the article below, we'll explore how to put together a portfolio to generate high yields from bonds, mutual funds, and individual dividend stocks for passive income.

1. Investments that offer risk-free income

The most basic rule of finance is that risk and reward are inherently linked. There are many ways to generate a low, but guaranteed return on your portfolio by using savings accounts, certificates of deposits (CDs), and investing in U.S. Treasury securities.

The investments that fall into the “guaranteed” category are probably best considered as savings vehicles rather than investment vehicles. That’s because the rate of return will likely be equal to, or slightly less than, the rate of inflation. Thus, these investments are best for money you might need in the not-so-distant future (say...five years or less), or for reducing the risk of your overall portfolio.

Savings accounts
Bank accounts offer a low return, but the amount you hold in a bank account is guaranteed by the FDIC in amounts up to $250,000 per year. Savings held in an account at a credit union are similarly guaranteed by the National Credit Union Share Insurance Fund (NCUSIF). That means even if your bank or credit union goes belly up, your savings (up to the insurance limit) will be completely safe from loss.

One advantage of a savings account is that they are extremely liquid. You can move money out of a savings account with little notice, withdrawing it as you need it or as you find better places to put it. The disadvantage is that this liquidity comes at a price -- even high-yield savings accounts pay a paltry yield on your deposits, currently less than 2% per year.

Certificates of deposit (CDs)
Also known as time deposits, certificates of deposit offer higher rates than savings accounts in exchange for agreeing to lock up your money with the bank for a certain amount of time. CDs give banks more predictability with respect to how much money they'll have to lend out, so they're willing to pay a premium interest rate on them.

Certificates of deposit usually last for terms ranging from one-month to 5 years, though some banks offer large depositors (think $50,000 or more) CDs on 7- and 10-year terms. The advantage of a CD is a higher rate than savings or checking accounts, but the disadvantage is that you can’t easily or quickly pull your money from a CD.

Most banks impose a penalty if you want to withdraw early. This penalty is usually assessed as a certain period of interest. For instance, a bank might charge a penalty equal to one year of interest to cash in a 5-year CD before the 5-year period passes.

For this reason, certificates of deposit are best if you are absolutely certain you won’t need the money until the CD matures. Though CDs may offer a higher yield than savings accounts, the penalty for withdrawing early can completely erase their interest rate advantage.

U.S. Treasuries
Lending your money to the U.S. Federal Government is as safe as it gets. The financial world considers U.S. Treasuries to be “risk-free,” because it’s virtually impossible that the government will be unable to pay you back. It’s pretty safe to lend money to an entity that can literally create its own money when it needs it.

Aside from the fact that U.S. Treasuries are super-safe, they also have a valuable tax shield. Interest earned on U.S. Treasuries is exempt from state and local taxes, whereas interest earned from savings accounts and CDs is taxable at the state and local level. Thus, if your state levies an income tax on interest income, as most do, then a U.S. Treasury security may offer a better after-tax yield than a income security that offers a similar pre-tax yield.

Some investors like to purchase U.S. Treasuries from the U.S. government through TreasuryDirect.com, though many more use mutual funds that invest in Treasuries instead. Vanguard Short-Term Treasury Fund Investor Shares (VFISX) manages a portfolio of short-term U.S. Treasuries on behalf of its investors, and charges a modest fee of just 0.20% per year for the convenience. 

2. Riskier income investments

Investors who want to earn an attractive, but riskier, income portfolio can look to bonds and preferred stock as a solution. These investments offer higher returns than risk-free income investments, albeit at the trade-off of having a greater potential for loss.

Corporate bonds
When companies need money, one way they raise it is by selling debt to the public in the form of bonds. Corporate bonds are a relatively low-risk investment, slightly riskier than U.S. government bonds, but they are certainly less risky than stocks. That's because bondholders are paid off first before stockholders in the event a company fails and is liquidated.

Corporate bonds are typically denominated in amounts of $1,000 of face value, and trade relatively infrequently, so most individual investors use mutual funds and exchange-traded funds (ETFs) to invest in a diversified portfolio of bonds in one easy transaction.

When analyzing funds, investors often use credit ratings to guide them. A credit rating is a letter grade that is assigned based on a rating company's assessment of the risk that a bond issuer will default on its bonds, and how much investors would lose if the bond were to go into default. 

Bonds are said to be "investment-grade" when they have a rating of BBB- or better (Baa3 on Moody's scale). Bonds with ratings below BBB- are said to be "junk bonds," which are issued by speculative companies that are more likely to default. 

One of the best ways to analyze a bond fund for credit quality is to visit the fund manager's website, or check a third-party information provider like Morningstar.com, to see its mix of bonds by credit rating. This gives you a high level view of any corporate bond funds' riskiness.

For example, by looking up the Vanguard Short-Term Corporate Bond ETF (NYSEMKT: VCSH) on Vanguard's website, I can quickly find that almost all of its bonds are investment-grade rated and set to be repaid in the next 5 years. That tells me it's a pretty low-risk bond fund.

Conversely, if I look up the SPDR Barclays Capital High Yield Bond ETF (NYSEMKT: JNK) on State Street's website, I can quickly see that almost all of the bonds it holds are rated junk or lower, and a majority are set to mature in 5 years or more. That's a good sign its yield, currently about 6.2% per year, is generated by taking higher risks.

Preferred stock
These securities bridge the gap between common stock and corporate bonds. Companies often issue preferred stock as a way to raise money for very long periods of time. Preferred stock also offers the ability for companies to raise money with fewer restrictions on how they use it, or how they manage their balance sheets in the future. From an investor's standpoint, preferred stock can be more attractive because, with a few exceptions, preferred stock dividends are taxed as dividends, rather than interest, thus scoring a lower tax rate than interest income.

Preferred shares sit just above common stock in the capital structure. So, if a company goes bankrupt, preferred shareholders are repaid after a company repays any loans, bonds, or other debt outstanding. That said, preferred stock is repaid before common stock, making it a slightly safer way to invest in a company than buying its common shares.

For individual investors, preferred stock is a tough asset class. That’s because very few companies actually issue preferred stock, and those that do are mostly limited to financial (banks) and real estate (REITs) companies.

The largest preferred stock ETF, iShares U.S. Preferred Stock ETF (PFF), has more than 81% of its assets invested in financials and real estate companies, based on my analysis of its holdings. So, buying this fund might diversify your portfolio by the types of investments you own, it also adds concentration risk from owning securities issued by companies in the same industries.

Preferred stock is much more accessible than other types of income investments because shares are often priced at $25 each, but it requires a very deep understanding of a company, its balance sheet, and the credit markets to truly understand -- skills that are far beyond the scope of this article. I'm mentioning preferred stock here for the sake of completeness, but I'd generally advise most individual investors from staying away from these complicated securities.

3. Tax-advantaged income from dividend stocks

Dividend-paying stocks can be an excellent way to generate income, and potentially earn additional returns from rising stock prices over time. Many of the largest companies have profits that exceed their reinvestment needs, so they pay dividends to their investors who own their shares, rather than letting the cash build up.

One advantage of dividends is that they are taxed at a lower rate than ordinary income. Thus, a dividend stock that pays a yield of 3% will likely generate a higher after-tax yield than an interest-paying investment that also offers a 3% yield. Of course, if you hold these investments in a tax-advantaged account, such as a 401(K) or IRA, the difference in taxation doesn’t matter.

Currently, the S&P 500 index offers a yield of about 1.8%, but there are dividend-specific funds that can generate even higher returns. For example, the Vanguard High Dividend Yield Index Fund is a mutual fund that holds about 400 of the highest-yielding dividend stocks on the market. It yields about 2.9%, or roughly one percentage point more than the S&P 500 because it uses yield as an important filter for picking stocks in its portfolio.

Picking your own dividend stocks

Investors who want to pick and choose their own dividend-paying stocks should look for companies that offer more than just yield. The best dividend-paying companies have competitive advantages that allow them to generate reliable earnings to fund dividend payments, and management teams who treat the dividend as a promise.

It's also important to build a portfolio that is diversified.

Wells Fargo (WFC -0.91%)
As one of the largest banks in the world (and one of the big four in the United States), Wells Fargo is often called America’s largest community bank. That’s because it primarily generates its revenue doing the basics -- taking in deposits and making loans.

Established banks benefit from switching costs. Changing banks is difficult and time-consuming to do, an activity that few find enjoyable. Therefore, customers rarely move their accounts, even if competing banks offer better service or higher interest rates.

Large banks are prolific dividend payers, because they earn far more income than they need to support their growth. Wells Fargo targets a payout ratio of 30-40% of its annual income, a policy I expect it to maintain for a very long time to come.

Apple (AAPL -1.32%)
While you can criticize this company as a one-trick pony (Apple might as well call itself iPhone Inc), one cannot deny that it has an obvious advantage in smartphones.

Apple's core advantage is derived from network effects and high switching costs. iPhone users enjoy easy-to-use features such as FaceTime and iMessage, which make its products more valuable when more people have iPhones or other iDevices, creating a network effect.

It also benefits from high switching costs, as users who have paid for iOS apps, backed up their important photos and contacts on iCloud, and familiarized themselves with the operating system over the course of years would be hard pressed to switch to an Android or Windows phone. It's much easier to pay a premium for an Apple device than switch to a different device.

Costco (COST -1.72%)
This wholesale retailer has an advantage that is nearly impossible to replicate: Costco sells only the fastest moving inventory at the lowest possible prices, going so far to create its own private-label brands when its suppliers aren’t willing to offer a better deal.

Costco's advantage comes from product selection. Whereas the typical Walmart Supercenter might have 140,000 different products on its shelves, the average Costco has only 4,000 different products. So, although Walmart's sales are more than three times Costco's, Costco's sales per product are substantially higher, giving it an incredible amount of power at the negotiating table.

Costco drives a hard bargain on everything from peanuts (it created its own Kirkland brand when Planters was unwilling to budge on prices) to credit card processing fees (it terminated a longstanding agreement with American Express in 2015 because Citi and Visa offered a better deal).

The income portfolio checklist

As you're building your income portfolio, there are a few questions that you should ask yourself to "stress test" your holdings and determine whether all the individual pieces come together to make a better portfolio. 

Is my overall portfolio yield reasonable?
If you put together an income portfolio and it spits out a yield of 8% per year, you’re likely taking an extraordinary amount of risk somewhere in your portfolio. I like to use the yield on the Total Stock Market Index as a benchmark for stock yields, and the 5-year U.S. Treasury yield as a benchmark for bonds and other fixed income investments. A yield greater than twice these benchmarks is a red flag.

If your stock portfolio has a yield of 4.5% at a time when the stock market as a whole yields just 1.7%, it’s pretty obvious that you’re swinging for the fences. If your bonds yield 10% at a time when U.S. Treasuries yield 2%, then you’re probably lending money to companies that are highly likely to have trouble paying you back.

Is my portfolio really diversified?
It’s way too easy to chase yields and end up with a portfolio that is invested in a long list of stocks, funds, and bonds that concentrated in one industry. I love Morningstar’s “Instant X-Ray” feature for analyzing a portfolio. Simply enter the stocks and funds you own, and it will show you which sectors you’re most heavily invested in, the ratio of stocks and bonds you own, and other details about your portfolio.

It's my view that a good income portfolio should have exposure to all 11 sectors that make up the stock market. 

Am I paying too much in fees and commissions?
Costs simply matter. Whether you earn 6.5% per year and pay 1.5% of your assets in fees and commissions, or earn 5.5% per year and spend 0.5% on expenses, the end result is the same: A net, after-fee return of 5% per year.

There isn't a perfect benchmark for what it should cost you to manage your assets, but I tend to think you should strive to keep the total cost of managing your portfolio to less than 1% per year, perhaps even less. 

For new investors who are just getting started, that may mean investing in funds, rather than individual stocks, until you have sufficient amounts of capital to justify paying $5 to $7 to place a stock trade.