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Published by Fidelity Interactive Content Services

Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.

4 income funds that yield 5%

We screened for funds that produce steady income while keeping an eye on risk. Here’s what we found.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 08/30/2012
  • Investing in Bonds
  • Investing in Mutual Funds
  • Bond Funds
  • Closed-End Funds
  • Mutual Funds
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Investors are searching far and wide for income these days. Government bond yields are near record lows with the benchmark 10-year Treasury yielding 1.65%. Quality corporate bonds pay just 3% on average, and even some riskier investments, such as real estate investment trusts (REITs), now yield less than 4%, near the lowest levels in a decade.

Yet while climbing the yield ladder isn’t without risk, financial advisers say it’s still possible to earn a decent income stream without stretching too far into dicey areas. A number of well-diversified, income-oriented mutual funds currently yield around 5%, investing in a variety of bonds and other types of assets. Less traditional investments offer ways to boost income further. Among them: energy master-limited partnerships (MLPs) and closed-end funds, some of which yield above 7%.

Granted, many advisers caution that investors shouldn’t stretch too far for yield. Just about every investment that pays more income has risks. Corporate bonds, for instance, are only as sound as the underlying cash flows from their businesses, and longer-maturity debt can tumble in a rising interest rate environment. That’s because the lower-yielding bonds become less desirable than bonds sporting higher rates.

Meanwhile, MLPs can take a hit if energy prices or demand for energy stocks tumble. And closed-end funds require careful analysis since they often use leverage to juice returns and may swing between discounts and premiums to their net asset value—creating layers of risk on top of their underlying holdings.

One tactic some financial advisers use to smooth out these risks is a "barbell" approach. The idea is to put cash and low-risk investments like Treasurys into one basket of your portfolio and balance it out with riskier assets in another basket. This way, losses in one part of the market may be offset by gains in another, and overall portfolio returns are likely to be less volatile.

"You can get a smoother ride even though each investment can be a roller coaster on its own," says Chad Carlson, an adviser with Balasa Dinverno Foltz, a wealth management firm in Itasca, Ill.

How much to put in each basket depends on a variety of factors, of course, including your age, time horizon and ability to handle swings in your portfolio value. Moreover, investors should set reasonable income goals. In a low-rate environment, even a 5% yield looks good, notes Carlson, while earning 8% or so probably isn't realistic in a moderate-risk portfolio.

4 funds that yield 5%

To find good options in the fund world, we looked for funds yielding at least 5% in several different categories. We screened performance records and eliminated funds that didn't score at least in the top 35% in their category over three- and five-year periods, according to Morningstar. Funds also had to have no loads or transaction fees, be open to new investors and have minimum investments of less than $10,000. Out of a universe of more than 5,000 funds, only a handful passed our screens. Below, our picks:

Fidelity Capital & Income Fund

  • Ticker: FAGIX
  • 30-day SEC yield: 5.33%
  • 3-year annualized return: 13.88%
  • Expense ratio: 0.77%

After years of strong returns, high-yield bonds are starting to look pricey. The average bond rated below investment grade now yields around 6.8%, near a record low, while prices are at a premium. That doesn't mean investors should rule out junk bonds, however. Yields are still high compared to Treasurys and investment grade corporate debt. Default rates have edged up in recent months to 2.7%, according to S&P, but remain well below the 30-year average of 4.5%. And corporate balance sheets are generally healthy, with higher levels of cash and lower debt than before the financial crisis.

Given this backdrop, many advisers recommend high-yield bonds for a small portion of their clients' portfolios. "We think high-yield bonds are still fairly attractive," says Brian Kazanchy, an adviser with RegentAtlantic Capital in Morristown, N.J.

One good option in the space: Fidelity Capital & Income Fund (FAGIX)

The fund's 13.88% annualized return over the last three years beats 85% of peers, according to Morningstar, and its 12.84% 10-year return beats 99% of high-yield funds.

One unusual aspect of this fund is that manager Mark Notkin may hold up to 20% in stocks. Notkin looks for growth stocks trading at reasonable prices and owns shares in companies such as Las Vegas Sands (LVS), LyndonellBasell Industries (LYB) and Apple (AAPL). Holding stocks can be a drawback in a down market, of course, but they help diversify the portfolio and offer potential for capital gains when bond prices are flat or falling.

Lately, Notkin has taken a more cautious approach to both the bonds and stocks in the portfolio. Over the last nine months, he's shifted into higher-rated bonds and away from riskier parts of the market. He's also cut economically sensitive sectors and shifted into defensive areas such as health care and utilities. "It's harder to find opportunities than it was three months and a year ago," he says.

Notkin has also cut his stock exposure to 7% of assets. True, stocks look cheap relative to bonds, based on the earnings yield of many companies relative to Treasurys, he says. But growth is slowing in China and Europe and there's a risk of tax hikes and spending cuts in the U.S.—all of which could pressure stock prices, he says.

One downside to this fund is its volatility. Notkin has traditionally invested in some of the riskier areas of the high-yield market and the fund suffered steep losses in 2008 when it sank 31.9%, trailing 87% of peers. The fund came roaring back in 2009 with a 72.14% return, however. And it has performed well so far this year, gaining 10.37%.

As long as the economy doesn't deteriorate, says Notkin, the bond prices should continue to hold up, and yields still look "terrific compared to Treasurys."

Manning & Napier Core Plus Bond Series

  • Ticker: EXCPX
  • 30-day SEC yield: 5.92%
  • 3-year annualized return: 8.76%
  • Expense ratio: 0.76%

While many corporate bond funds stick to the upper tiers of the investment-grade universe, holding debt with at least an A credit rating, this fund roams a bit more freely. It can hold up to 20% of its assets in junk bonds and 20% in non-U.S.-dollar foreign debt. This freedom to invest where the analysts see bargains has paid off with an 8.76% annualized return over the last three years, beating 80% of peers.

Run by a team of analysts based near Rochester, N.Y., the fund now has about half its assets in BBB-rated corporate debt, which may sound risky since that's just above junk. But the Triple-B market has grown in both size and diversity in recent years as the big bond-rating agencies have downgraded a wide variety of bonds, and the lower ratings don't necessarily reflect poorer credit quality, says Jack Bauer, managing director of fixed income at Manning & Napier.

Many of the fund's BBB bonds were issued by banks that are now financially stronger, more conservative in their lending and more tightly regulated, he explains. Deemed too big to fail by the federal government, "they'd get help if they ran into trouble." The fund also holds bonds issued by real estate companies that have strengthened their finances, he adds, and industrial companies whose balance sheets are stronger than they were before the recession.

Like any corporate bond fund, this one has downsides. Another financial shock or contagion from Europe's debt crisis could depress bond prices; and if Washington fails to address the "fiscal cliff" of spending cuts and tax hikes coming in 2013, corporate bonds would likely sell off as investors sought safer havens. Indeed, the fund has been hurt in "risk off" markets: The big gains in Treasurys in the third quarter of 2011 wiped away the fund's outperformance for the year. "If we got rid of that quarter, we'd look like geniuses," says Bauer.

For now, Bauer and his team still see value in corporate bonds and think the bigger risk is in Treasurys. True, Treasury bonds may rally in a flight to safety, but yields remain meager and the supply side picture looks "ugly," he says, with the Treasury Department issuing more than $1 trillion a year in debt—a flood of bonds that's likely to hold prices in check.

PIMCO All Asset All Authority Fund

  • Ticker: PAUDX
  • 30-day SEC yield: 5.55%
  • 3-year annualized return: 9.92%
  • Expense ratio: 2.03%

Traditional balanced funds hold a mix of stocks and bonds to smooth out returns. PIMCO All Asset All Authority Fund (PAUDX) goes a few steps further. A "fund of funds," it invests in an array of PIMCO strategies, from Treasury Inflation Protected Securities (TIPS) to commodities, stocks, real estate and foreign bonds. The idea is to diversify broadly and make tactical shifts to find the best returns with the least risk.

Run by Robert Arnott, an academic theorist who heads his own research firm, the fund targets "real" returns of 6.5% above the consumer price index (CPI) over a full market cycle. And Arnott ventures far and wide to try and achieve it. He currently has 43% in emerging market and global bonds, 18% in global stocks, 15% in "alternative strategies," and just 1.9% in U.S. stocks, reflecting his view that prices are high for U.S. equities and yields are too low to hit his return targets.

Despite his free reign, the fund hasn't swung to wild losses. It fell just 7.52% in 2008 when the S&P 500 (.SPX) lost 37% and volatility is only a fraction of the S&P's. Returns are also more stable than the average mixed-asset fund, according to Lipper.

Granted, investors expecting roaring returns may be disappointed in this fund. It has lagged far behind the S&P 500 during exceptionally strong years for stocks, such as 2006 and 2009. Another downside is that annual expenses are on the high side at around 2%.

Still, the fund beat 96% of funds in the Lipper "flexible portfolio" category over the last three years. And it can be a good one-stop shop for investors willing to give up some upside for lower volatility and steady returns. "There are some big advantages to this kind of flexibility in a fund," says Tom Roseen, head of research services at Lipper.

TCW Emerging Markets Income Fund

  • Ticker: TGINX
  • 30-day SEC yield: 5.34%
  • 3-year annualized return: 15.45%
  • Expense ratio: 1.15%

Investors seeking higher bond yields have poured $14.9 billion into emerging market bond funds this year, according to Lipper. The quest for yield has bid up prices and helped drive a 12% average return in emerging market bonds—beating developed market bonds and even global stocks.

Yet many advisers still recommend emerging market bonds for investors with a long time horizon. Compared to the developed world, economic growth is stronger in developing countries, government debt levels are generally lower and bond yields are mostly higher—an attractive investment backdrop. Moreover, many companies and countries now have investment-grade ratings and potential for ratings upgrades, which could give bond prices another lift.

"You're getting a premium for companies in markets that have stronger growth and you're getting more income," says David Robbins, co-manager of the TCW Emerging Markets Income Fund (TGINX), which has returned 11% annualized over the last five years, beating 98% of peers, according to Morningstar.

Robbins and his team can invest in both dollar-denominated bonds and local currency bonds, wherever they see the best value; they now have 45% in corporate bonds and 92% in dollar-based debt. The fund's largest stake is in Brazil, where Robbins thinks economic growth should pick up and corporate bonds issued by companies with good domestic growth look attractive. He also ventures into some far-flung markets to add a bit of income; the fund holds a small stake in Nigerian government bonds, for instance, which yield upwards of 17%.

While emerging markets have stabilized since the 1990s, they're still a volatile corner of the global market. Prices may plunge if there's a sell-off of risky assets, and the steep rise in prices over the last few years won't last forever. Nonetheless, yields remain attractive compared to developed-market bonds. And with central banks in the developed world committed to holding down interest rates, emerging market bonds may continue to lure yield-hungry investors.

Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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© 2008-2013 Fidelity Interactive Content Services LLC. All rights reserved.
Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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