Income Funds: How to Find the Right Fit

10/03/2011 12:30 pm EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

They guide you through some hard-to-navigate investment categories and provide instant diversification, writes Rob Carrick, reporter and columnist for The Globe and Mail.

A strategy we’ll call Retirement 1-2-3 figures into the financial thinking of a lot of people:



  1. Sell family house.
  2. Slice off some of the proceeds to invest.
  3. Buy investments to generate income that augments money coming in from pensions, registered plans, and government programs.

The dynamics of the housing market will have a big effect on how well this retirement strategy works for you, but let’s say you’ve made it through Steps 1 and 2. Now comes the difficult task of finding the right investments to pay a reliable stream of investment income.

With the help of Dan Hallett, director of asset management for HighView Financial Group, let’s look at income-producing mutual funds and ETFs. You can certainly build your own portfolio of income-paying stocks and bonds and save on fees. But there’s hardly a better argument for the fund approach to investing than there is in the income category.

Funds—and this includes both mutual funds and ETFs—offer diversification through exposure to a wide range of income-producing investments. With a small portfolio of your own, one bad choice could really hurt.

Income funds also offer a way to buy into investment categories that are tricky for individual investors. Take preferred shares, for example. They can provide yields in the 4% to 5% range, but there are several different kinds, each with their own virtues and weaknesses.

High-yield bonds can also be challenging for individual investors. They offer better yields than most government and corporate bonds, but also a higher risk level. That’s a key consideration at a time when economic weakness has raised the risk of bond defaults somewhat.

So, what does Hallett see as an ideal mix of investments for an income-paying fund?

"I don’t think it needs to get too fancy—a mix of domestic and foreign stocks, some preferred shares for the higher yield, and on the bond side a mix of government, corporate, and maybe a little high-yield as well. On the stocks side, you’d potentially include some REITs or other types of high-yielding equity."

When evaluating a fund’s mix of investments, remember that the safety of bonds in today’s market has to be weighed against the tax benefits of dividend income. Thanks to the dividend tax credit, a dollar of dividends is worth more on an after-tax basis than a dollar of bond interest in non-registered accounts.

A practical consideration in selecting funds is the frequency of distributions of income. More and more mutual funds and ETFs are distributing income to unitholders on a monthly basis, which is helpful for managing your household cash flow.

Fees are an important issue at a time when low interest rates are depressing returns from bonds, which are a significant component of most income funds. Note that some income funds are actually "fund of funds" products that bundle various separate funds into one income-producing whole. Don’t worry about the fees charged by the underlying funds—only the fee for the income fund itself applies.

Hallett suggests management expense ratios should be no higher than 1.5% or so if you’re a do-it-yourself investor. Higher fees may be unavoidable if you have an advisor who provides financial planning and other services.

Now, we come to what for many investors is the most important consideration in choosing an income fund. It’s the yield, or the return they get from a fund’s income distributions.

The annualized distribution is divided by the latest fund unit price to calculate the yield. Interpreting the yield requires some context.

For example, Hallett said the yield for the broad Canadian bond market now is in the range of 2.3%, and the corporate-bond universe yields about 3.2%. A well-run income fund should provide a higher yield than that, but how much higher?

To answer this question, it’s worth reviewing how income distributions actually work. Bond interest, dividends, and cash distributions from REITs are the big component, but in some cases a return of capital is used to pump up the cash distributions even further.

Basically speaking, a return of capital means a fund is paying you cash over and above the taxable income generated by the investments it holds.

Each return of capital payment has the effect of lowering the cost of the fund that you will use at some point in the future to calculate your capital gain (or loss) when you sell. But there’s more to the return of capital than tax. If a fund’s income payments plus changes in unit price are less than the cash payout, the unit price will start to decline.

Eventually, it may become necessary for the fund to cut its payout. If you’ve become accustomed to living with a certain amount of cash from a fund, that could hurt.

Hallett said funds yielding in the 7% to 8% range or more demand close scrutiny to see how sustainable the distribution is. At up to 6%, a fund’s cash payouts can generally be considered reliable.

Consult a mutual fund or ETF company’s Web site to find out how much return of capital is paid out by an income fund. The information may be contained in regularly updated fund profiles, or in the most recent semi-annual management report of fund performance.

Shortcut suggestion: Do a Google search along the lines of: "XYZ Income Fund distributions tax."

There’s no way around the fact that the fees paid to own an income fund reduce your returns. Once you’ve paid the purchase commissions, a portfolio of individual bonds, GICs and stocks could deliver more income.

The upside of income funds is that they guide you through some hard-to-navigate investment categories and provide instant diversification. For a well-managed fund with a sizeable but sustainable flow of income, that’s a fair bargain.

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