Mutual Fund Site

Income funds fall under the fixed income category of mutual funds. A lot of investors confuse this category of investment as encompassing little or no risk, or are surprised that even though these funds consist of bonds they are still part of the mutual fund class of investment. Unlike equity mutual funds, income funds typically come with less risk and volatility. For investors, the main reason for investing in fixed income securities is for the fixed income that bonds and other fixed income securities provide, not for capital appreciation (although in the past, such instruments have provided profitable capital gains for institutional and retail investors alike).

It makes sense that when investors think of income, they naturally think of securities that offer fixed interest rates which obviously translates into fixed rates of income. And in its most popular forms, these securities will normally include:

• term deposits
• bonds
• annuities

But there are other types of income that these types of funds will invest in, including:

• preferred shares
• dividend paying common shares
• treasuries

For the most part, income funds will limit their holdings to the bonds and preferred shares as these are more in line with the returns such investments require in order to meet the unit holders’ income requirements.

Like equity investment funds, income funds have many different sub-classes. This allows the sophisticated investor to diversify among this asset class. Such sub-classes include the following:

• Government Bonds
• Corporate Bonds
• Municipal Bonds
• Junk Bonds
• Convertible Bonds
• High Yield Bonds
• Domestic Bonds
• Foreign Bonds

Of course, there are others but those listed above are among the most popular and definitely are readily available through your planner or advisor. But not all of the above classes are for everyone as many of them entail considerably higher risk than your core bond fund.

Risks To Bond Funds

The most common risk to a bond is interest rate risk. This is seen most often in periods where interest rates increase, making a bond at a lower rate less attractive to investors (remember, income is the primary objective when purchasing fixed income instruments and capital appreciation is secondary). To illustrate, consider a Bond that you purchase today for $100,000 at a rate of 4.5%. Your annual fixed income will be $4,500 from today until the bond matures. Suppose two months later that rates increase to 5%. While your income stays the same at $4,500 you might decide that you need the cash for something else, so you put your bond up for sale. Even though the maturity value of your bond is $100,000, how do you compete on a market where rates are now 5%? In other words, why would an investor choose your bond that will give her $4,500 when she can purchase a bond on the market that will give her $5,000? She wouldn’t. So you need to make your bond more attractive and reduce your asking price for the bond.

Luckily, there is a formula in place that provides bond investors with a fair value of a bond when rates fluctuate. This fair value is reflected in the market price of the bond. In the example above where current rates have increased since you bought your bond, your market value will actually drop so that someone can justify taking a little less income by paying a little less for the $100,000 par value.

The other common risk to fixed income securities is currency risk as all bonds are denominated in a specific currency (no, they are not all denominated in US Dollars). This risk can also provide a currency hedge for investors.

At the Mutual Fund Site, our focus is primarily on equity mutual funds. While we certainly understand and appreciate the importance that income funds play in portfolio construction (they are necessary, even in highly aggressive portfolio and even during periods of rising interest rates), our focus is primarily on equity funds. (That is our excuse for such a short list of covered bond funds).

The two pure income funds that we cover at this site are:

Janus High Yield Fund (JAHYX). This is a high yield play but is considered higher risk for many investors. We recommend this fund for investors with high investment knowledge and a strong appetite for risk. This fund was also our Top Fixed Income Fund Pick for 2010 and outperformed the S&P 500.

PIMCO Total Return Fund (PTTAX). Arguably the most recognized and strongest income fund on the market, the PIMCO Total Return Fund is managed by superstar bond fund manager, Bill Gross. In most market scenarios, we would pit this income investment fund against some of the toughest equity funds and bet that Bill Gross would come out victorious, but given the shift in rates as well as the low absolute rate on bonds, we see at least one or two years of underperformance vis-a-vis equity funds. Still, for conservative investors who want something that is high quality and managed by one of the best minds around, this is an easy decision.

Yes, slim pickings. We realize that and will make an effort throughout 2011 to beef up our coverage of income funds. In the interim, investors seeking income from equities might consider Balanced Funds or Dividend Funds.