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Mutual Funds and the Perpetual Quest for Income

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Key Points

  • Interest rates on traditional income-providing investments have been near historic lows for some time.
  • Income-seeking investors may be unintentionally taking excessive risk in reaching for yield to compensate for today’s low rates.
  • Schwab’s Income Mutual Fund Select List identifies a broad range of income-producing mutual funds in a variety of asset classes to help investors seeking to boost their income.

With interest rates stubbornly hovering near historic lows, income-seeking investors are finding themselves increasingly discouraged. Rates on traditional sources of dependable payouts—money market funds, U.S. Treasury notes and government bonds—continue to be meager. Despite one federal funds rate hike in December 2015 and the prospect of additional increases in the foreseeable future, it will understandably take some time for interest rates to rise appreciably. In fact, they may never return to levels to which investors had become accustom in the not-so-distant past.

To meet their income needs in the meantime, some investors may be tempted to reach for yield— unintentionally increasing their risk by shifting into investments such as high-yield bonds, master limited partnerships (MLPs) or other higher-yield asset classes to compensate for today’s discouragingly low rates. There are, however, other ways to generate income than from traditional fixed-income vehicles such as bond funds and money market funds. A balanced strategy has the potential to help investors meet their income needs while also addressing the issue of portfolio sustainability over the long term.

Limited Yield Opportunities in Today’s Market

Bonds and bond funds constitute the most common asset class associated with income-generation. By paying interest—measured by yield—individual bonds provide a predictable payout on a regular basis. Bond funds, typically comprising a diversified portfolio of individual bonds, have a somewhat less-predictable payout because they are constantly replacing maturing bonds with newer issues with potentially varying rates and durations. In either case, however, income is generated through interest. But in today’s low-rate environment, yield opportunities are disappointing by historical standards, especially for traditional investment-grade and municipal fixed income securities, as the chart below shows.

Yield for a variety of types of bonds
 

Consider a Total Return Approach

Rather than relying solely on interest and dividends for income, we suggest that investors broaden their definition—and potential sources—of income. Equity funds that invest in dividend-paying stocks, for example, also offer the opportunity for income. And, in addition to a regular payout, such funds also offer the potential of share-price appreciation. This combination of income and capital appreciation is known as “total return.” It’s an investment approach that is followed by many institutional investors, such as university endowments and pension plans, to help them meet their ongoing funding needs while minimizing downside risk and looking to long-term sustainability; but it also may be appropriate for some income-seeking individual investors. Incorporating both yield and price appreciation in a portfolio can not only boost returns but also smooth an income stream, given inevitable market fluctuations.

Investors interested in adopting a total return approach will want to identify a range of asset classes that could help them achieve an acceptable balance between risk and reward, given their goals, time horizon and risk tolerance. Possible asset classes or fund categories include:

  • Taxable bonds/funds
  • Tax-free bonds/funds
  • Foreign bonds/funds
  • Domestic stocks/funds
  • Foreign stocks/funds
  • Real estate (both domestic and global)/funds
  • Balanced funds, which typically hold a mix of equities and bonds

Due to the myriad of possibilities, investors may feel overwhelmed by the sheer number of choices and the time and effort required to identify those funds that are suitable for their specific situation. That’s why Schwab developed the Income Mutual Fund Select List®, which is an integral part of the highly valued Mutual Fund OneSource Select List®.

Putting the Income Mutual Fund Select List to Use

Updated quarterly, Schwab’s Income Mutual Fund Select List identifies a broad range of income-producing mutual funds—fixed-income, equity and balanced funds that focus on dividend income. Fixed-income funds are broken out by taxable and tax-free and their duration (short-, intermediate or long-term); equity funds are categorized into domestic, international and real estate funds, and further distinguished by characteristics such as style (value, growth or blend) and size (small, mid or large). Like the Mutual Fund OneSource Select List, the Income Mutual Fund Select List is developed and overseen by Charles Schwab Investment Advisory, Inc. (CSIA). All funds are no-load and no–transaction fee and have met CSIA’s rigorous criteria. In addition to applying the same quantitative and qualitative factors used to evaluate funds for the Mutual Fund OneSource Select List, including performance, risk, expenses and assets under management, CSIA also assesses each fund’s ability to generate income in its respective asset class, evaluating funds not only on the basis of current yield but also using other measures, such as three- and five-year income distributions, to determine each fund’s likelihood of generating income going forward.

For all funds on the list, performance is shown over standardized periods, along with upside and downside market capture ratios (measures of how much a fund moves in comparison to the broad market when the market rises or falls) and annual operating expenses. For equity funds, the Income Mutual Fund Select List shows the dividend yield, last payment date, and the amount paid per share. For fixed-income funds, in addition to the information presented for equity funds, average weighted maturity and 30-day yields are shown.

Considerations in Selecting Income Funds

Despite the most vigilant planning, your portfolio’s yield is impacted by factors beyond your control, such as prevailing interest rates and market conditions. In addition, a fund’s income distributions can change over time. But in evaluating funds and developing an effective, appropriate income-producing portfolio, there are many factors that investors can control—at least to some degree. They include:

  • Diversification: Even the most conservative investors should consider maintaining at least some exposure to equities for the capital appreciation potential they provide.
  • Risk vs. Return: Different categories or asset classes reflect varying risk/reward trade-offs. Consider a mix of bond funds, and be cognizant of a fund’s exposure to below–investment grade bonds, which come with greater risk.
  • Maturity: Bond funds with longer maturities can leave investors exposed to greater inflation and interest-rate risk, so consider a balance of maturities, from ultra-short to long.
  • Distribution Frequency: Different funds provide payouts on different schedules. Check the frequency of distributions to match funds to your income needs.
  • Taxes: Pay attention to tax implications, particularly in non-retirement accounts, where interest is generally taxable; interest from municipal bonds, however, is generally exempt from federal income tax. In tax-deferred accounts, such as IRAs and 401(k)s, taxes are less of a concern until withdrawals begin.


Not Just for Retirees

Over time, as an investor’s time horizon shrinks and his or her risk tolerance moderates, it’s natural to shift from a growth-oriented portfolio to an income-oriented one. But it’s not only retirees—or near-retirees—who seek income. Younger or more conservative investors may also seek income, for a variety of reasons. For all of them, it’s important to remember that although fixed-income investments may generally be more stable, they may not keep up with inflation, thereby eroding the purchasing power of a portfolio even as the dollar amount remains steady. By looking beyond traditional income-generating vehicles, investors can develop and maintain a suitably diversified portfolio that provides both income and the prospect of growth—which could help sustain income for the long haul.

Need help picking funds?

Even if they understand the premise of total-return investing and the various asset classes that comprise it, many investors are uncomfortable or uninterested in doing the legwork required to determine the optimal mix and how much income a portfolio is likely to produce. If that’s the case, Schwab is here to help. Speak with a Fixed Income Specialist at 800-626-4600.