Investors selecting an interest income fund consider returns, potential changes in bond values, costs, fees, and tax effects. Income investing targets periodic income payments, but total investment return may be affected by changes in bond values, fees, and taxes. Investors may choose investment-grade corporate bonds, junk bonds, emerging market bonds, or bank loans. Longer maturity terms are more sensitive to interest rate changes. Fund management fees should also be considered. Municipal bonds may provide tax exemptions.
When investors select an interest income fund such as a bond mutual fund, the selection criteria could include the level of returns on the fund’s bond holdings, any future changes in bond values, the fund’s costs and fees, and any tax effect on interest income. Income investing is primarily concerned with receiving periodic income payments. Your total investment return, however, may be further affected by potential changes in the values of the fund’s underlying bonds, fees charged by fund management and any taxes paid on interest earned.
Investors interested in an income investment might choose an interest income fund that invests in investment-grade corporate bonds that pay interest in excess of the safest government debt yield while preserving the capital of the investment. Depending on individual investors’ risk tolerance, income investing may also target bond funds that invest in high-yield securities known as junk bonds. In exchange for higher interest income, investors bear a higher potential risk of default.
Emerging market bonds and some bank loans also pay higher yields than investment-grade corporate bonds. An interest income fund that invests in emerging market bonds may be the choice for some income investors who are also looking to diversify into overseas markets. Some income funds may invest in a niche category of bank loans that pay higher yields comparable to junk-rated bonds but with specific assets as collateral. Another benefit of an interest income fund with bank loan participations is that their interest is usually paid on a floating rate basis, which works best in an environment of rising interest rates.
The value of an interest income fund will likely fluctuate over time as the prices of the bonds in the fund change in response to changes in market interest rates. A decline in fund value when investors sell their fund shares is equivalent to capital losses. This reduces the total investment return despite a satisfactory level of interest income.
For income securities, the longer the maturity terms, the more sensitive their market price to a given change in the interest rate. This means that there would be a greater increase or decrease in price than for securities with shorter maturities. In a rising market condition, for example, investors would be better off investing in short-term bond funds whose value would decrease the least when an increase in the interest rate causes all bonds to decrease in value.
Fund management fees should also be a major factor to consider when choosing an interest income fund. Income investing does not typically provide a high degree of capital appreciation compared to investing in stocks. Any additional fund costs should be absorbed directly by interest income, reducing your total investment return. To boost investment returns, investors may also want to look into funds that have a portion of their holdings invested in certain municipal bonds, because the interest earned may be exempt from certain taxes.
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