The battle is joined in the income investing world. On the one hand, strong companies are putting up solid results and show every sign of continuing to do so. On the other, interest rates appear to be doing their annual thing, with the benchmark 10-year Treasury note yield pushing close to 4.9 percent in Friday’s trading.

A rising interest rate environment is negative for income investments in two ways. First, it makes their yields relatively less attractive. That pushes down their prices, so yields can adjust higher. In addition, some traditional income payers like utilities are also big borrowers, so rising rates can mean higher interest payments on debt and hence, lower earnings.

The second way a rising rate environment hurts is purely psychologically based but often far more damaging, at least in the near term. Unlike the stock market of just a couple decades ago, Wall Street today is dominated by big institutions and money managers who are under great pressure to put up good performance numbers every year, and often quarter-by-quarter.

When these guys see a trend moving in one direction or another, they move quickly. During the first half of 2006, interest rates started moving up. At first there was relatively little reaction in the market. Then the benchmark 10-year T-note yield finally broke above 5 percent and panic set in.

The T-note sold off sharply and the yield approached 5.3 percent.

That selling quickly spread to bonds of all types and then all manner of high-yielding stocks as well. By the time the selling peaked in early July, all manner of income investments were well under water for the year and the consensus forecast much bigger losses ahead.

The reversal came just as swiftly. The 10-year T-note yield began diving in mid-July and never looked back, ultimately bottoming in December at a rate of about 4.4 percent. As for other income investments, the second half of the year was one of the more profitable in memory.

The exception was Canadian income trusts, which were battered by the government’s Halloween surprise that it would begin taxing them as corporations beginning in 2011. But everything else rallied full out. Utilities--which had been declining since the middle of 2005--reversed the slide and moved to new highs.

Last year’s interest rate ups and downs were basically a reprise of the market action during the three prior years. In 2003, the rate spike occurred during the summer months, temporarily trashing income stocks. It then subsided and income stocks rallied into the end of the year. In 2004 and 2005, the spike occurred in the spring and was over by summer, at which time the rally began.

Market psychology swung wildly each year. Those who moved with it--selling into the spike and buying back in later--had a rough go of things. In contrast, those who bought into the spike and sold into the rally were able to trade quite profitably.

For income investors, however, the best approach each time was simply to stick with high-quality stocks, adding incrementally to holdings when prices came down and generally standing pat when the institutions were rushing in. That remains the best approach today, as we appear to entering another period of interest rate volatility.

BEHIND THE MOVE

Many investors I talk to believe that the Federal Reserve’s upward push on interest rates was responsible for last year’s rate spike.

Many blame the Fed’s apparent decision not to cut rates this year for the current upward push.

In reality, these rate spikes have had little to do with Fed actions. In fact, the central bank was basically standing pat in both 2003 and 2004 with the federal funds rate it sets at low, expansionary levels.

Rather, the rate spikes have been due first to growth scares that gained momentum over a period of months. Also, there’s a more technical factor, namely the desire of large investors particularly to shift to growth stocks at the beginning of the year and then pull back to safer income investments in the year’s waning months to avoid big losses.

Hope springs eternal on Wall Street, particularly at the beginning of the year. Big investors try to make the big bets in the early months that will carry their performance through for the rest of the year. Typically, that means unloading the safeties, such as utilities and real estate investment trusts (REITs).

With the market softened up, the stage was then set for a growth scare. Typically a piece of news has come out that seems to portend stronger economic growth. That boosts Wall Street consensus expectations for growth, triggering inflation fears. In 2004, for example, an employment report indicating the economy was creating more jobs than expected set off the fireworks.

Each time, the so-called catalytic event proved to be a false alarm.

Eventually, other news emerged that made clear the economy was still running at the same steady pace it has in recent years. And with growth not accelerating, fears arose that higher borrowing costs would slow things down.

In effect, the rise in rates literally sowed the seeds of the subsequent decline. It was the momentum of a lot of big money sloshing around that created the volatility and the potential losses.

I certainly don’t have a crystal ball. But I do have a sense that the bond market wants to go lower and that market interest rates are therefore going to go higher.

The Federal Reserve may try to influence things one way or the other. Or it may just continue in its Hamlet-like repose, periodically issuing cryptic comments about inflation worries or recession. Either way, they’ll have little impact on what happens.

Rates will rise and cause panic for at least some investors who will dump their income investments. Prices will be driven down for high-quality investments across the board. At some point, the realization that growth and inflation are still in the same place they’ve been for the past few years will set in. Interest rates will drop and income investments will rally.

Here, in brief, is where I see the various income investing sectors for the next few months. Again, my philosophy is to maintain a mix of high-quality, high-yielding investments across a broad range of sectors, adding to positions when prices drop.

UTILITIES: This sector has pulled back slightly already this year, as interest rates have ticked up. Earnings, however, have rarely looked better, at least for the companies that have reported this season to date. Rates will likely hold sway for the time being and then prices will come down a bit. Establish new positions incrementally; continue to hold any solid company.

REITS: This group actually continues to surge, but the buying has shifted to takeover speculation. Meanwhile, valuations are extremely high and yields are low. The basic business is strong, particularly for office buildings and residential real estate, so risks are generally low to dividends. But REIT preferred stocks are a better bet for high income and stability.

CANADIAN TRUSTS: This once-popular sector has stabilized, except for oil and gas producers, which continue to be hit by weak energy prices. The tax proposal is well reflected in prices and any tweaking in a positive direction would create a buying surge. In the meantime, the best of the group outside oil and gas, like YELLOW PAGES INCOME FUND (TSX: YLW.UN, OTC: YLWPF), are strong bargains for income. The best oil and gas producers, like ENERPLUS RESOURCES (TSX: ERF.UN, NYSE: ERF) are great plays on a rebound in energy prices and takeover targets besides.

BONDS: My view here has always been to buy for income, rather than capital gains. I prefer shorter-duration funds like VANGUARD GNMA (VFIIX) to longer-maturity ones. Also, high-yield bond funds and lower-rated individual bonds in companies with improving balance sheets will buck any upturn in interest rates, even as they pay higher yields than those with better credit ratings. Watch those premiums to net asset value on the closed end funds. Those tend to close up when rates rise, triggering losses for investors.

SUPER OILS: Oil may be making a goal-line stand in the mid-$50s per barrel range. If so, the likes of CHEVRON (NYSE: CVX) and other Super Oils that dominate its markets stand to gain considerable ground, even if interest rates remain volatile. In the meantime, there’s no real risk to Super Oil dividends and they’re about the lowest-risk way to play oil.

BANKS: Most big money center banks should be unceremoniously dumped, but strong regional banks are a super alternative. And they pay superior yields as well.