Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond funds, money market funds and balanced funds pay interest because of the coupon-bearing debt securities in which those types of funds invest.
How Do Mutual Funds Distribute Income?
Mutual funds distribute income to shareholders through capital gains distributions or dividend distributions. Interest earned by a fund's assets is paid as a dividend distribution.
To avoid paying taxes on earnings, mutual funds are required to pass on all net income to shareholders at least once each year. However, if the assets in the fund's portfolio pay interest more frequently, such as monthly or quarterly, the fund is likely to make dividend distributions that match the payment schedule of its assets.
Types of Mutual Funds That Pay Interest
Bond funds, as the name implies, invest in corporate or government-issued debt. While not all bonds pay interest annually, the vast majority of them do.
The interest paid by a bond fund is a direct result of the coupon payments generated by the bonds in its portfolio. Unless the fund includes zero-coupon bonds, each security in the portfolio pays a set amount of interest each year, called its coupon rate, which is then passed on to shareholders according to their investments in the fund.
Money Market Funds
Money market funds also invest in corporate or government debt, but only in very short-term issuances that mature in less than a year. These types of mutual funds are generally considered the most stable type of fund, since they invest primarily in government bills and notes or very highly-rated corporate debt with maturity dates under three months.
Like bonds, these types of debt securities pay annual interest that is passed on to shareholders as dividend distributions.
Interest-Bearing Balanced Fund
A balanced fund is simply a mutual fund that includes both debt securities and equity securities. These funds generally make dividend distributions comprised of interest from both debt assets and dividend payments from investments in the stock market.
Like bond and money market funds, balanced funds generally pay some interest each year. However, if one of the goals of the fund is to minimize shareholders' tax liabilities, the fund manager may choose to avoid interest-bearing debt or dividend-paying stocks altogether.