Fixed Income Funds: Income and Diversification

When it comes to portfolio allocation, many financial professionals suggest devoting a portion of a portfolio to fixed income investments, such as Treasury securities, corporate bonds, and similar vehicles. But how do you decide which to buy? And how concentrated are you willing to be in any one security?

There are many different categories and products of fixed income instruments to choose from, each with their own unique set of potential benefits and risks. But if you'd like to spread your investment among many different types of fixed income investments, you might consider fixed income mutual funds.

Fixed income mutual funds—commonly referred to as income funds—are a type of mutual fund that holds a basket of fixed income securities, such as government bonds, corporate bonds, international bonds (government and corporate), and money market instruments. 

Some funds may focus on a single category of fixed income (e.g., U.S. Treasury bonds or money markets), while other funds may mix and match categories. Here are a few basic categories of fixed income mutual funds and what, in general, each offers.

If you're looking for steady income with almost no change in the value of your principal investment, you might consider money market mutual funds. The yields may be lower than other fixed income funds, but in exchange, their net asset values (NAV) hardly change at all, hovering at or near $1 per share.

Money market mutual funds invest in short-term, high-quality debt and cash equivalents that are often exchanged between large corporate and financial institutions. Comprised of short-term debt, money market instruments tend to be less risky than their longer-term counterparts.

Interested in receiving income payments from government debt? Government bond fixed income funds, such as federal securities (U.S. Treasuries) and municipal bonds (a.k.a "munis"), can potentially provide income streams for investors. Treasuries are debt instruments issued by the federal government, while municipal bonds are debt instruments issued by a particular city, state, or municipality.

One potential advantage of investing in these funds is that some of your income stream may be tax-exempt on a federal and/or state level. But as with all mutual funds, if you sell your positions at a realized gain, then the profit is subject to capital gains taxes. There may also be taxable year-end capital gains distributions made to shareholders.

If you're looking for higher yield, you might want to consider an income fund in the corporate bond category. Bear in mind, however, that yields generally correspond with a company's creditworthiness. So, given the same lengths of time to maturity, a higher yield typically means a riskier bond.

Company bonds considered "investment grade" are less risky, but their yields tend to be lower. Bonds issued by companies that are financially distressed or have poor credit ratings are often referred to as "junk bonds." Because of the additional risk, these low-rated bonds typically offer higher yields as a means to attract investors.

On the brighter side, investing in corporate bonds through a diversified income fund with a large number of holdings can help reduce your risk if a particular company defaults on its debt obligations. With a broad-based fund, you wouldn't lose your entire principal, which can happen if you invest in a bond directly and it defaults. With an income fund, you may experience a drop in your fund's NAV.

Like the broader market, the global economy undergoes cyclical changes. And like individual stocks, sectors, countries and currencies, the fixed income market also "rotates" in economic strength. This is one reason an investor may consider diversifying their fixed income prospects across the globe.

Investing in international fixed income funds is one way to gain exposure to foreign government and corporate bond income. You'll also be diversifying your portfolio with assets denominated in currencies other than the U.S. dollar. Bear in mind, though, with international exposure comes exchange rate risk. Currencies fluctuate, so money invested abroad will rise and fall as foreign currencies rise and fall relative to the dollar.

Though not traditionally considered part of the fixed income family, mutual funds holding dividend-paying stocks can potentially be a source of income for investors. Comprised of stocks, this also means their NAVs tend to be more volatile than most other income funds, just as the stock market tends to be more volatile than the bond market over the long term. While dividends may be taxed as ordinary income or capital gains (be sure to check the fund's prospectus), any profits you generate by selling shares will likely be subject to capital gains taxes. Also, dividend-focused funds may underperform funds that do not limit their investment to dividend paying stocks. 

And remember, dividends aren't guaranteed. Even a company with a long history of dividends and dividend growth could cut, or even eliminate, its dividend at any time.

Now that you have a clearer picture of the various assets fixed income mutual funds hold, how might you find and compare these funds? In other words, which mutual fund is right for you?

One way to start is to research a mutual fund category or a more general mutual fund list. After deciding which category of fixed income fund you're targeting, consider the following:

• Management fees and expense ratios: Some income funds cost more than others. Try to figure out the total annual cost for a given fund and compare it with similar funds. Once you see the bigger picture in terms of expense, you might want to compare a fund's costs against its past performance to determine if it meets your objectives.
• Track record: It's important to understand that past performance doesn't guarantee future results because the market, economy, and every asset within it undergoes cyclical changes. Nevertheless, a fund's track record can still be helpful when looking at a fund’s performance over time across various market cycles.
• Minimum investment requirements: Can you afford to buy into a given fund? Each fund has a different minimum investment, so be sure to research this limit to find funds that meet your budget.
• Recurring purchase programs: This feature allows you to invest in a given fund (or funds) on a weekly, semi-monthly, monthly, or quarterly basis. It can be helpful to build exposure to this part of your portfolio over time.
• Other considerations: Fees and taxable events vary across funds. Be sure to read the prospectus carefully before investing in a fund. Consider whether the underlying securities and overall fixed income fund categories match what you're looking for.

Remember, there is no sure-shot investment. But a well-diversified portfolio, which might include fixed income investments, may help you pursue a steady stream of cash flow for discretionary spending, savings enhancement, or perhaps retirement income.