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

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  2. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  3. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  4. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  5. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  6. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  7. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  8. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  9. Mutual Funds & ETFs

    The 8 Most Popular Vanguard Funds for a 401(k)

    Learn about some of the mutual funds in Vanguard's lineup that are popular among 401(k) investors, and find out why you should consider them.
  10. Financial Advisors

    Ditching High-Yield Bonds for Plain Vanilla Ones

    In a low-rate environment, it's tempting to go for higher yield bonds. However, you might be better off sticking with the plain vanilla ones.
  1. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  4. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  5. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  6. When are mutual fund orders executed?

    Whether buying or selling shares of a fund, mutual fund trades are executed once per day after the market close at 4 p.m. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center