For many people, the reliability of dividend or interest income is one of the primary benefits of investing. Like individual stocks and bonds, mutual funds can be a great source of dividend income. However, not all mutual funds pay dividends, so if generating regular dividend income is important to you, learn which types of funds pay the highest dividends.

Dividend Stock Funds

For those who are primarily interested in generating regular dividend income but are willing to take on some risk for the chance at capital gains, dividend stock funds can be an excellent choice. These funds are focused on investing in stocks that have reliable track records of paying healthy dividends each year. Since paying dividends to shareholders is considered a sign of a company's financial stability, many companies pride themselves on issuing increasing dividends each year.

Dividend funds are not focused on identifying the next Wall Street darling, unless it pays dividends, but all stock investments have the potential to increase or decrease in value based on market fluctuations and the performance of the issuing company. Though dividend funds are not focused on creating capital gains, the stock of a healthy company that pays significant dividends is likely to go up over time, potentially increasing the value of the fund.

Dividend Bond Funds

Unlike stock funds, dividend distributions made by bond funds are actually the result of interest income generated by the bonds in the fund's portfolio. The interest rate, or coupon rate, paid by a bond is influenced by many factors, including the credit rating of the issuing entity and national interest rates at the time of issuance. While the interest rates of bonds issued by very stable, creditworthy corporations and governments tend to mirror rates set by the Federal Reserve, less stable entities often offer bonds with higher rates because the risk they will default on their financial obligations due to insolvency is greater.

High-yield dividend bond funds, therefore, invest in very low-rated bonds, called junk bonds, because they pay extremely high rates of interest to compensate investors for the increased risk of default by financially unstable issuing entities. Though the dividend income from these types of funds can be substantial, it comes at considerable risk. Other less-risky bond funds make more moderate dividend distributions but carry much lower risk of loss.

Advisor Insight

Dan Danford, CFP®
Family Investment Center, St. Joseph, MO

A lot of people think of investing like a bank account. So, they automatically ask about the interest rate, dividend or yield. However, interest or dividend payments are just part of the total value-add, as the valuation of investments are also a big part of the equation.

Total return is the calculation that takes all these factors into account. This is important because many high-quality investments don’t provide regular income. Most large companies, for instance, pay a relatively low cash dividend even though the share price might be expected to rise over time.

In fact, this could be good for investors because dividends are taxable and growth in share value is not until you sell the shares. Therefore, if you really want growth, look for investments offering potential total returns.