Income investors’ best move in 2007 will be the same as it is every year: continuing to build and manage a diversified portfolio of the highest-quality securities, represented by growing businesses in a wide range of sectors.

In any given year, some sectors of the market outperform and others lag. Owning a mix means some of your holdings will shine while others slump. But overall performance will be steady.

In contrast, overweighting one sector or another can yield stellar results, but it can also produce disastrous ones. That’s OK if you’re an aggressive investor, a speculator or have many years before you have to start living off of your investments. But the point of income investing is to generate steady returns over a long period of time, so you never have to eat your seed corn in a bad year. And that goal is simply incompatible with the practice of overweighting sectors.

In 2006, we saw some income investment sectors produce superb returns. Utility stocks, for example, halted a roughly year-long decline to bounce back to new highs by the end of the year. Selected real estate investment trusts (REITs) did the same, boosted by a wave of takeover speculation.

At the beginning of 2006, neither sector enjoyed anything close to the same level of excitement that Canadian royalty and income trusts did. Utilities were still in the middle of a sharp decline from the past year’s highs. REITs were widely--and rightly--perceived as way overvalued.

Both sectors took a hit last spring, as interest rates finally broke out on inflation fears and the Federal Reserve’s relentless upward push on the Federal Funds rate. The benchmark 10-year Treasury note wound up moving as high as 5.3 percent, its highest level in several years, wreaking havoc on bonds, preferred stocks and virtually every other income investment type as well.

In contrast, Canadian trusts--particularly those involved with producing oil--entered the New Year pretty much on a roll. The Liberal government had been forced to back off a fall 2005 proposal to begin taxing trusts as corporations and subsequently lost the January election to the Conservative Party, which pledged during the election to leave trust taxation alone.

With their yields well above those of other income investment sectors and the outlook seemingly bullish for energy, many investors saw little need to buy anything else but oil and gas trusts.

Unfortunately, energy prices--particularly natural gas--weakened in the winter and spring. Then came the Conservative Party’s Halloween flip-flop on the trust issue and the record one-day crash on November 1, which the recovery since has only partly retraced.

Worse, natural gas producing trusts have weakened further during the past few weeks as gas prices have sunk on mild winter temperatures.

The result is that trusts across the board have been among the weaker income investments. That’s especially been true in the second half of the year.

If your timing had been perfect, you could have concentrated on trusts in the first half of the year then moved heavily to utilities and other income groups when the 10-year Treasury note yield peaked.

Unfortunately, that would have been absolutely the most difficult course to take emotionally. Moreover, making the swap would have been a matter of pure guess work.

Fortunately, you could have accomplished close to the same thing by practicing balance. In other words, when something appreciates to the point where it’s a disproportionate percentage of your holdings, it’s time to lighten up. The funds should then be redeployed in other holdings that are high quality but not as high priced in the market.

Periodic rebalancing is a practice all income investors should make it a resolution to follow for 2007 and the years ahead. It’s a far higher percentage game than trying to see the future, which invariably involves looking through a darkened glass. Nonetheless, here’s how I see the various income investing markets for the year ahead.

BONDS AND PREFERRED STOCKS:
Fixed income securities’ fate as always will be heavily impacted by the ups and downs of inflation, and the Federal Reserve’s reaction to it. Last year, the Fed halted its string of interest rate increases. The primary reason was emerging evidence that at least some segments of the US economy were slowing down, particularly housing. The Fed, however, didn’t reduce rates as some expected, and instead continued to make statements that fighting inflation was still its main concern.

As far as the economy went, the pattern of the past year followed that of the last several. Every piece of evidence pointing to faster growth and inflation seemed to be countered by another showing the opposite. The breakout of the 10-year Treasury note yield over 5 percent was a change from 2005, 2004 and 2003, when rate spikes stopped short of that figure. But the primary reason was the Fed’s own rate-hike progression, not a breakout for inflation or economic growth.

Heading into 2007, there’s nothing to suggest anything has changed.

And with the Fed seemingly determined to keep inflation under control--without inducing a recession--it’s unlikely to do anything dramatic either. There’s still a strong possibility of a spring spike in interest rates, as has happened the last few years. But if there is one, it will merely be a solid buying opportunity.

The best bonds and preferred stocks to own are still those of companies in the mid-level credit range whose businesses are getting stronger. My favored sector remains regulated utilities--the only sector with a nearly perfect record of financially recovering from any disaster. Best bets include securities issued by AQUILA (NYSE:ILA), CMS ENERGY (NYSE: CMS), SEMCO ENERGY (NYSE: SEN) and SIERRA PACIFIC RESOURCES (NYSE: SRP).

One group to avoid is the US automakers. FORD (NYSE: F), in particular, has weakened dramatically during the past year, basically putting up all of its US production assets as collateral on a new class of debt. Unlike regulated utilities, the company faces tremendous competition, both domestically and overseas. Also unlike utilities--which produce an essential service that’s always in demand--automakers are extremely vulnerable to a slowing economy.

UTILITY STOCKS:
Following a very rocky start, 2006 turned out to be another strong year for regulated utilities. First, the interest rate spike ended. Then, utilities turned in quarter after quarter of strong earnings. Finally, there was the exodus of US funds out of Canadian income trusts and back to the tried and true, notably utilities.

From a fundamentals standpoint, most utilities are in good shape to start 2007. Credit ratings have stabilized, as companies continue to repair their finances and their core markets tighten. Even after the crushing defeat of Republican incumbents on both the state and federal level in the November 2006 election, regulation has only potentially worsened in a few states, and most of them were already moving in that direction anyway.

The one problem in the sector is price. We’re again back to yields well below 3 percent in many cases, and some companies are trading at 20 times earnings or more. That makes new buying a matter of careful selection. But there’s little real risk to what investors already own. REITS: Strong REITs are priced even higher than

utility stocks. In fact, they’ve mostly been taken over by institutional buyers far more interested in the property than the dividends. The exceptions are the apartment REITs, which lagged for several years due to low mortgage rates that discouraged renters.

Also, Canadian REITs are still relatively high yielding and cheap, and they have stronger balance sheets and occupancy rates as well.

As for commercial US REITs, income investors should generally avoid them for now. Some will be taken over for relatively high prices this year. But a lot of the good news has already been priced in, and there’s little income advantage to them. Again, keep the REIT portion of your portfolio in apartment REITs and the Canadians and out of the big US names.

SUPER OILS:
The Super Oil stocks were supposedly the big losers from the Democrats’ rise to power. But in reality, little will change for the companies that dominate the world’s traffic of black gold in 2007, or in the years thereafter.

Democrats have promised to take serious action to reduce America’s dependence on imported oil. And as I’ve pointed out, there are some serious technologies that can do that, including electric vehicles and battery technology.

Nonetheless, we’re still a long way from the kind of conservation, adoption of alternative energies, major new conventional reserve discoveries and global recession that ended the 1970s bull market for energy. And with mild winter weather depressing prices now for oil and natural gas, we’re not likely to see any such transformation in 2007, or even the next few years thereafter.

The result is the Super Oils will continue to enjoy a lock on meeting the bulk of the country’s energy demand. In fact, their market power grows every time prices dip and smaller rivals are run down. If there’s a problem to buying them in early 2007, it’s that their prices have run up steeply during the latter half of 2006.

That’s likely due in part to exodus of money from Canadian trusts.

In any case, Super Oils are bedrock for conservative portfolios. The only one I’d avoid is BP (NYSE: BP), which continues to have safety and environmental troubles in the US that could trigger blow-ups and subsequent penalties from the US government.

CANADIAN INCOME TRUSTS:
The damage has been done in this group. We now know the worst case for the sector: corporate taxation beginning in 2011 with no penalty for converting from trust to corporations and a potential to double in size by then. And this bad news is now well priced into trust shares.

If there are any further changes, they’ll almost certainly be a positive for trusts. Some possibilities include a 10-year grandfathering for trusts that’s supported by the Bloc Quebecois, rather than the current four-year window. It’s also still possible that the entire plan will be abandoned.

Even if that doesn’t happen, however, there will still be trusts that will pay strong dividends to 2011 and well beyond. Others will become takeover targets, as did CALPINE POWER INCOME FUND (TSX:CF.UN, OTC: CLWIF) in December. And still others will continue to grow rapidly in the coming years, becoming ever-more valuable businesses and ultimately corporations.

The bottom line is the sector is far from dead. In fact, trusts remain a valuable part of a balanced income portfolio. The key is to focus on those with healthy businesses, just as it was before the potential tax changes were announced. Note that oil and gas producer trusts are going to follow oil and gas prices in 2007, just as they did before.

Mild temperatures are now expected throughout the winter. That will depress demand for natural gas and related oil distillates like heating oil. On the other hand, the OPEC has shown its ability to curtail supply of oil, and Canadian production of natural gas is dropping markedly even as the oil sands region is demanding more.

That adds up to a mixed picture for oil and gas this year. Most likely, companies and Canadian trusts that produce oil will continue to prosper, while those relying more heavily on natural gas will suffer. The weather, of course, will remain a wildcard, as will the possibility of political unrest in oil producing nations.

The best course is to own producers that are roughly balanced between production of oil and gas. These are the strongest players in the sector and the best way to play the potential for higher prices in 2007 and beyond.

BANK STOCKS:
Banks do better when the economy is growing and interest rates are relatively stable. Both should generally be the case in 2007, though there could be some serious ups and downs along the way. I continue to prefer regional banks, which are growing and remain takeover targets as well. I would avoid most money center banks.