Historically low interest rates have created a challenging environment 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, mutual funds can provide monthly income and daily liquidity. 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.
Generally, a mutual fund that has a greater potential for higher income and total return (income + capital gains) also has a higher risk of short-term and long-term volatility. Conversely, if you build a less aggressive portfolio that has a lower allocation to funds that invest in stocks and high yield bonds, you might experience reduced volatility. However, over the long-term, you might earn lower income and reduced total returns.
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.