Investors seeking current income and diversification have many alternatives to choose from with income mutual funds. These funds can invest in either debt or equities or a combination of both. This article examines the various categories of income funds and the types of investors for whom they are appropriate.

Regardless of what type of underlying security an income fund invests in, most income funds share a few common characteristics, such as diversification and professional management. Most income funds pay either interest or dividends (or both) on a monthly basis. Some funds are more liquid than others and the yields on almost all of them rise and fall with interest rates. Many income funds invest internationally or globally, while others are strictly domestic. Some pay interest, others pay dividends and a third category of income funds combines an element of growth with the income.

SEE: Income Funds 101

Fixed-Income Funds

These funds invest chiefly in securities that have set maturities and rates of interest. They can be appropriate for both conservative and aggressive investors, depending upon the type of securities in the fund. The total returns posted by these funds are largely determined by interest rates.

Bond Funds
This is generally the most recognized category of income funds and usually the most appropriate for conservative investors. Bond funds invest in either government, municipal or corporate debt, and can have varying degrees of risk. As with individual securities, government bond funds are the most conservative. Some government bond funds invest solely in treasury securities backed directly by the full faith and credit of the U.S. government, while others offer slightly higher yields by allowing government agency securities, such as Ginnie and Sallie Maes, into their portfolios. However, even though these funds invest solely in instruments backed either directly or indirectly by Uncle Sam, they still cannot guarantee the principal of their investors, because changes in interest rates cause bond prices to fluctuate in the secondary market.

Municipal bond funds are appropriate for high-income investors seeking tax-free income from revenue generated by municipalities. Corporate bond funds provide investors with fully taxable income, albeit at a higher rate than either government or municipal funds. Corporate income funds perhaps vary the most in terms of risk and yield; they can invest solely in very conservative, highly-rated corporate offerings or speculate in the high-yielding junk bond market. They are categorically considered the riskiest of the three types of bond funds, as the underlying securities that they invest in have the greatest risk of default.

SEE: Bond Funds Boost Income, Reduce Risk

Specialty Fixed-Income Funds
There are two primary types of income funds that do not invest in bonds. One of these is prime rate funds, which are also known as floating rate or bank loan funds. These funds invest primarily in senior secured loans that banks made to corporations and are usually fully collateralized. These funds also tend to vary somewhat in terms of liquidity; many of them are accessible only on a monthly or quarterly basis. The other major category of specialty is mortgage-backed funds; these funds invest in pools, or tranches, of commercial and residential loans and pass the interest on to the shareholders.

SEE: Consider Prime Rate Funds For More Income

Equity Income Funds
These funds tend to be appropriate for income investors seeking higher yields with higher risk. Their holdings consist both of common and/or preferred stocks, as well as real estate.

Stock Income Funds
The most common type of stock income fund invests primarily in utilities. These funds pass on monthly dividend income to investors seeking higher yields than can usually be found in bond funds. Utility fund share prices tend to remain fairly stable, as do most of their underlying holdings. Other funds invest in preferred stock offerings that also remain relatively constant in price and pay steady dividends at competitive rates, with yields often at least 1 to 2% higher than government bonds.

Real Estate Funds
Although there are exceptions, most real estate funds invest almost solely in commercial properties. Many of these funds can also be classified as growth and income funds, as their holdings often provide income from rental revenue as well as capital appreciation. Some funds invest directly in properties, but many of them own their holdings through real estate investment trusts (REITs), which are unit investment trusts (UITs) that invest primarily in commercial properties. These funds can also be very tax-efficient through the use of special rules to defer gains on the sale of properties within their portfolios. However, because they are sector funds, their returns tend to be more volatile, due to lack of diversification.

Growth and Income Funds
These funds are usually combinations of both debt and equity holdings, with the debt generating current income while stock or real estate positions provide an element of growth. They can be appropriate for investors with a primary objective of either growth or income, who want to hedge their bets. Conservative growth investors can reinvest the income produced by the fund to gain greater returns over time, while income investors can keep pace with inflation by allowing the equity in the portfolio to appreciate. The growth proceeds can then be reinvested to increase their share balance and thus increase the amount of monthly income they receive.

The Bottom Line
There are many types of income funds - some conservative, some less so. They can be an important component in many portfolios and satisfy a number of different types of investment objectives.

Related Articles
  1. Investing

    2 Common Ways to Misuse Target Date Funds

    The world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Mutual Funds & ETFs

    What Target-Date Funds Can Teach About Investing

    Target-date funds are a popular way to invest for retirement. Here's what they can teach the novice investor.
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  6. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  7. Investing Basics

    Are ETFs the Best Way to Diversify with Bonds?

    Are bonds safe or risky right now? It depends on the type of bond and how you invest in them.
  8. Professionals

    How to Navigate Taxable Mutual Fund Distributions

    It's almost time for year-end capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact.
  9. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  10. Mutual Funds & ETFs

    Top 4 Communications Mutual Funds

    Discover some of the best mutual funds in the communications sector, and learn how investors can position investments within these funds.
  1. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  2. How do mutual funds compound interest?

    The magic of compound interest can be summed up as the concept of interest making interest. On the other hand, simple interest ... Read Full Answer >>
  3. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  4. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  5. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
  6. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!