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Home / Mutual Funds

Mutual Funds

An Overview of Income Funds

Investors who need high current rates of return often turn to long-term funds, seeking current income. Generally, these funds pay dividends on a monthly or quarterly schedule that is stated in the fund's prospectus. 

Most income-oriented funds invest in debt securities, such as corporate or government bonds. High dividend-paying stocks are sometimes featured in their portfolios also.

As with most investments, the potential rate of return for funds seeking income is usually counterbalanced by the potential degree of risk. So, higher-yielding investments generally incur a greater degree of credit risk than lower-yielding investments. 

This trade-off between risk and return marks the area where most income funds differ from each other. And, since the majority of these funds invest in bonds, their risk can usually be determined by the yields, quality, and average maturity of the bonds in their portfolios.

Key Notes regarding Income Funds

Yield: 

Funds that invest in long-term bonds will generally offer higher yields than funds investing in short-term bonds.

Price Stability: 

Funds that invest in short-term bonds generally experience less share price fluctuation than funds that invest in long-term bonds of similar quality.

Interest Rates: 

Funds that invest in bonds will be affected by changing interest rates. Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall, and the converse is also true. 

However, as interest rates rise, dividends paid by the fund can increase, resulting in higher current income. In general, long-term bond funds will be more sensitive to changes in interest rates than short-term bond funds.

Quality: 

Funds can differ greatly by the quality of the bonds in their portfolios. A bond's quality is determined by the bond issuer's ability to pay off its debt. For instance, U.S. Treasury bonds are considered to be of the highest grade because payment of principal and interest is guaranteed by the U.S. government. 

Fund share prices and yields, however, are not guaranteed and will vary with market conditions, even though the portfolio may contain U.S. government securities.

Tax-Free Income Funds

Most investments require individuals to pay income taxes on their returns. Fortunately, mutual funds that invest in municipal securities are one of the exceptions. Municipal securities are debt instruments (bonds) usually issued by state and local governments and their agencies. 

They are unique because the interest earned on most of these bonds is free from regular federal income tax. In the state of issue, municipal bonds are often free from both state and local income taxes as well. Mutual funds that invest in municipal securities pass on this tax-free interest to shareholders who, in most cases, earn monthly dividends.

Key Notes about Tax-Free Income Funds

High Credit Quality: 

Municipal bonds generally are considered to be high on the investment safety scale, second only to securities issued by the Indian government or its agencies.

Tax-Free Yields: 

Although municipal bonds pay tax-free interest, their yields are generally lower than similar taxable investments. However, since the interest income is free from taxes, investors actually may keep more income from the tax-free security.

Click here to learn more about Gilt Funds.

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