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.

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