Not prepared to take on the risk of high-growth, high-return funds?

MOST investors building their portfolio equate unit trusts with funds that invest in stocks, with the emphasis on growth. But while capital appreciation is well and good, investors should not ignore funds whose main aim is to offer a good income stream with some prospect of capital gains as well.

There are three types of income funds: equity income funds, bond income funds and balanced income funds.

In order for an equity income fund to pay dividends, it has to invest in companies that show a strong dividend-paying ability. These funds usually invest in well-established companies that pay high dividends, like banks and utility companies.

Income bond funds, on the other hand, usually invest in bonds with high coupons and good credit ratings. This assures the fund that it will be able to keep up its stream of payouts to unit holders. There are some funds called high-yield bond funds which invest in emerging markets. These offer higher rates that also come with a higher risk of default.

A balanced fund invests in both high-dividend stocks and bonds with high coupons.

Having a high-income instrument in your portfolio gives you some buffer in a bear market. Stocks that pay high dividends tend to have lower downside relative to the broader market in a bearish environment. Being able to maintain dividend payouts in such an environment also reflects the company's strong fundamentals.

What to look for

So what does one look for in a good income fund? Much the same things one looks for in a good equity fund: performance over different time frames, length of time the manager has been with the fund, expense levels, sales charges and tax treatment.

However, investors must first evaluate their own risk tolerance. If they are fairly risk-averse, then investment in treasury or government funds is probably best. If their risk tolerance is moderate, they can include mortgage and investment grade corporate bond funds. For example, there are funds investing in Freddie Mac and Fannie Mae debt issues because they finance low- and mid-income housing.

Those with a high risk tolerance can include all of the above as well as emerging market and high-yield funds.

The low correlation of US high-yield bonds to other assets classes allows investors to diversify their portfolio by potentially offsetting negative movement in other asset classes. And if interest rates start to turn up, these bonds will also be less affected, being more sensitive to the issuing company's credit fundamentals such as cash flow. So compared to traditional bonds, prices of high-yield bonds tend to be less sensitive to interest rate movements.

To investors with a higher risk tolerance, high-yield income funds offer certain benefits over equity funds, such as a higher risk-reward ratio. Also, as most of the returns come in the form of interest payments, high-yield funds are ideally suited to investors with low tax rates.

Investors must also understand the kind of risks faced by income funds in general. First, there is the credit risk within the fund's portfolio. While debt rated lower than AAA may bring marginally higher returns, the chances of defaults are higher. The fund managers have to balance the quality of debt and the overall return. Generally, investors should consider funds which have 70-75 per cent of investments in AAA debt.

Then there is interest rate risk. Income funds are sensitive to interest rate changes, due to the inverse relationship between rates and bond prices. Interest rate trends would dictate the maturity of the portfolio. If the fund manager assumes that the easy interest rate regime will continue he would buy longer dated bonds of say, four or five years. If the reverse is expected, the manager will opt for shorter duration paper.

Investors must also note that the distribution of income is not certain and the quantum is at the manager's discretion. Hence, investors who are looking for a fixed income stream may be disappointed. Another point to note is that some funds are allowed to distribute income from capital gains instead of dividends or interest.

Finally, investors are advised to go for medium- to large-sized funds. The small funds are susceptible to fluctuations should a large investor sell out.

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