Building a portfolio of income-producing mutual funds

Rising interest rates have created opportunities as well as challenges for income-oriented investors. If you are among those trying to earn an attractive yield on your savings, it’s important to balance your desire for income against the inherent risks of investing in equities or fixed income securities.

When building a diversified portfolio of income-generating investments, certain mutual funds can provide monthly income. They also provide diversification potential and professional management, which means you don’t have to worry about managing your fixed income investments on a day-to-day basis. Building a diversified portfolio of funds starts with identifying your investment goals, then understanding how different types of funds align with your objectives, risk tolerance, and time horizon.

A diversified portfolio of income-generating mutual funds can include funds that invest in domestic and international stocks; government, municipal, and corporate bonds; real estate; and other assets. The challenge is to pick the right combination of funds to match your investment time horizon, your investment goals, and your stomach for volatility.

If you are the type of investor who might be tempted to abandon course and sell your holdings at a loss due to short-term market fluctuations, you may want to err on the side of caution. For most investors, it’s usually better to build an asset allocation you can stick with for the long haul, rather than take on too much risk and overreact to routine market volatility.

When selecting mutual funds for your income portfolio, funds from the following categories are among the potential choices for most investors:

  • Investment grade taxable bond funds are typically composed of investment grade bonds issued by governments and corporations or secured by assets such as home mortgages. All fund yields are subject to taxes at the local, state, or federal level, and in some cases, a combination of all these.
  • Municipal bond funds invest in bonds issued by state governments and municipalities. While yields may be somewhat lower in comparison to other funds, all yields are typically free from federal income taxes.
  • High yield bond funds invest primarily in lower credit quality securities, including convertible securities. While they have the potential to provide high income and total returns, they are riskier and more volatile than their investment grade counterparts are.
  • Equity income funds invest in stocks that pay high dividends. This strategy, known as equity income investing, can be an attractive alternative to bond investing, as it seeks to offer greater protection against inflation as well as the potential for capital appreciation.
  • Asset allocation funds offer exposure to a variety of asset types. This strategy can provide diversification, seeks to reduce the impact of market volatility, and provides a source of income as well as an opportunity for capital appreciation.
  • International and global bond funds invest in securities issued by companies from around the world, including those based in emerging markets. The main distinction between global and international bond funds is that the former invests in US securities whereas international bond funds do not.
  • Emerging market bond funds invest primarily in bonds issued by countries with smaller, less developed economies, or by corporations headquartered in developing countries. While these types of bonds generally represent higher risk than those from developed nations, the risk profile of each fund will vary according to the credit quality of the individual bonds it holds.

Because these funds may generate income, they also may generate tax consequences. That makes it important to consider whether to hold them in a taxable brokerage account or in a tax-advantaged account, such as an IRA, 401(k), or a health savings account (HSA).

Municipal bond funds may be best suited to being held in a taxable account where their exemption from federal (and potentially state) income tax may help lower your tax bill.

If you’re not taking withdrawals prior to retirement, the tax bill on your income-producing funds in tax-deferred accounts (like 401(k)s or Traditional IRAs) will be deferred until you retire, when you may find yourself in a lower tax bracket. They may even be tax-exempt if you follow the withdrawal rules for accounts such as Roth IRAs and HSAs.

What’s your ideal mix?

What’s the right mix of income-generating funds for you? As discussed above, the answer will depend on your goals, risk tolerance, and time horizon. In some cases, you may be able to achieve the diversification you need with a single multi-sector fund. Or perhaps a portfolio of individual mutual funds would enable you to achieve the diversification you need across different sectors, maturities, credit qualities, and yields.

While past performance does not guarantee future results, history has shown that diversifying your assets among different asset classes, industries, and countries can potentially improve the long‐term performance of your portfolio.

Keep in mind, however, that certain asset types involve greater risk than others do. Diversifying your investments across asset classes, industry sectors, domestic, and international funds may help minimize your overall exposure to sudden market swings. However, remember that diversification alone will not ensure a profit or guarantee against loss.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds.

[There are additional considerations for bonds issued by foreign governments and corporations.] Foreign debt can be more volatile than U.S. dollar denominated debt due to the impact of currency fluctuations as well as risks of adverse issuer, political, regulatory, market or economic developments. These risks may be more pronounced in emerging markets, which may be subject to greater social, economic, regulatory, and political uncertainties. Investments in debt denominated in a foreign currency involve exchange rate risk, which is the risk that a decline in the value of the local foreign currency relative to the U.S. dollar will have an adverse impact on the value of your investment once principal and interest payments are converted back to U.S. dollars.

Interest rate risk - Like all fixed income securities, the market prices of municipal bonds are susceptible to fluctuations in interest rates. If interest rates rise, market prices of existing bonds will decline, despite the lack of change in both the coupon rate and maturity. Bonds with longer maturities are generally more susceptible to changes in interest rates than bonds with shorter maturities.
Call risk - Many municipal bonds carry provisions that allow the issuer to call or redeem the bond prior to the actual maturity date. An issuer will typically call bonds when prevailing interest rates drop, making reinvestment less desirable for the holder. Some municipal bonds, including housing bonds and certificates of participation (COPs), may be callable at any time regardless of the stated call features. In some cases, bond issuers will call bonds to modify an indenture through a new offering. Investors should also be aware of special or extraordinary redemption provisions. These are provisions that give a bond issuer the right to call the bonds due to a one-time occurrence, such as a natural disaster, interruption to a revenue source, unexpended bond proceed, or cancelled projects.
Liquidity risk - The vast majority of municipal bonds are not traded on a regular basis; therefore, the market for a specific municipal bond may not be particularly liquid. This can be attributed to the large number of municipal issuers and variety of securities. With limited exceptions for some large more actively traded issues, the chances of finding a specific municipal bond in the secondary market at any given time are relatively small. According to the Municipal Securities Rulemaking Board (MSRB), it is much more common to identify basic characteristics of a municipal bond in which an investor is interested in investing (e.g., state, creditworthiness, maturity range, interest rate, or yield, market sector, etc.) and then to make a choice from a set of municipal securities that meet those criteria. Selling prior to maturity can present a challenge for municipal bond investors due to the fragmented and thinly traded nature of the market.
Revenue sources risk - With revenue bonds, the interest and principal are dependent on the revenues paid by users of a facility or service, or other dedicated revenues including those from special taxes. In general, the consumer spending that provides the funding or income stream for revenue bond issuers may be more vulnerable to changes in consumer tastes or a general economic downturn than the income stream for general obligation bond issuers. "Essentiality" is a key investor consideration for a project financed with revenue bonds. For example, a facility that delivers fundamental or essential services, such as water and sewer, may be more likely to have dependable revenues through multiple economic cycles. When evaluating revenue bonds, it is important to consider:
The overall economic health of the region or customer base and the impact it might have on the entity's ability to sustain its revenues.
The exact source of the revenues that will service and repay the debt. Is the bond solely dependent upon one source of revenue or is a larger entity standing behind the issue?
The entity's track record of operational effectiveness through multiple economic cycles. Is there a track-record of solid growth attracting more customers or taxpayers from more diverse sources?
The legal provisions that may be in place to protect the bondholder, such as rate covenants and debt service reserve funds.
The competence of financial management of the entity. Has its credit rating been maintained or strengthened over a period of time? How has it weathered previous economic downturns? How much debt does it have? How much of its cash flow is committed to paying down debt vs. investing in new projects or supporting services of value for the community?
Credit and default risk - Credit risk is the risk that the issuer will default or be unable to make required principal or interest payments. Despite the fact that many municipal bonds have high credit ratings, there is a risk of default in any bond investment.
Tax risks - Because tax-exempt interest generated by municipal bonds is usually more beneficial for investors in higher tax brackets, municipal bonds may not be appropriate for all investors, particularly those in lower tax brackets. In addition, if you are subject to the federal alternative minimum tax (AMT), the interest income generated by certain municipal bonds (mainly private activity bonds) may be taxable.
Inflation risks - with all bonds, investors run the risk that inflation will diminish the purchasing power of a municipal bond's principal and interest income.
Repudiation risk - There can be no assurance that bonds validly issued will not be partially or totally repudiated by the issuing state or municipality, should that be deemed reasonable and necessary to serve other important public purposes.
Other risks - Not all risks can be quantified in a bond's prospectus or offering circular. A type of risk called "special event risk," lawsuits or significant legal changes, another community's public works project, unusual weather, an economic downturn, or other events could impact the issuer's ability to meet their financial commitments.

Although bonds generally present less short-term risk and volatility than stocks, the bond market is volatile and bond funds do entail interest rate risk (as interest rate rise, bond prices usually fall, and vice versa). This effect is usually more pronounced for longer-term securities. Bond funds also entail issuer credit risk, and the risk of default, or the risk that an issuer will be unable to make income or principal payments. Additionally, bond funds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

Fidelity does not provide legal or tax advice, and the information provided is general in nature and should not be considered legal or tax advice. Consult an attorney, tax professional, or other advisor regarding your specific legal or tax situation.

Investing involves risk, including risk of loss.

Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

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