Investing in income-oriented funds can be a great way for income investors to balance risk and yield. Below, profiles of two popular types of income-generating funds: floating rate funds and equity income funds, plus recommendations from each group. First, Mark Salzinger, editor of the No-Load Fund Investor, on equity income funds:
“Equity income funds generally are perceived as lower-risk stock funds whose characteristics have helped them earn returns comparable to the broader market. Although they didn’t perform as expected in 2008, we think that some changes to their makeup and a ‘return to normal’ in the investing world make them worthy of consideration by conservative equity investors.
“The average equity income fund strives to generate a stream of income greater than an investor could earn on a broad-market index fund, like the S&P 500, before expenses. It favors value stocks (about 45% of the average portfolio), particularly large-cap value (about one-third of the portfolio). This historically has given equity income funds their heaviest weightings in sectors that dominate the large-cap value space, including financials and industrials. Unfortunately, this was also their undoing in 2008, when financials and economically sensitive stocks led the market’s dive. Worse yet, the emphasis many equity income funds place on below-average valuation led their managers to snap up shares in falling stocks too early, dragging fund performance down as they fell even further. ...
“Equity income funds’ long-term performance suggests that their underlying strategy has merit. The average equity-income fund posted a 10-year annualized return of 3.8% through Mar. 31, 2010, trouncing the 0.7% annualized loss of the S&P 500. .
“We recommend Parnassus Equity Income – Inv (PRBLX). The fund is unique among equity income offerings for many reasons, but it stands out particularly because of its outstanding track record. Foremost among its differences is the fund’s ‘socially responsible’ investment criteria. In addition to criteria for above- average growth prospects, sustainable competitive advantages and attractive valuation, Parnassus funds consider the ways in which companies demonstrate politically progressive behavior as it relates to the environment, the workplace and business ethics. They also eschew makers of alcohol, tobacco and weapons; companies involved with gambling; and nuclear power.
“The fund has an unusual composition relative to its peers. Manager Todd Ahlsten, who has managed or co-managed the fund since 2001, is required to invest just 75% of the portfolio in dividend-paying stocks. He keeps the portfolio relatively concentrated in only 40 to 50 positions, and has only about 25% of the portfolio in ‘value’ stocks, according to Morningstar. Its heaviest sector weighting is in technology (about 20%), a sector that typically gets marginal attention from most other equity income funds. Healthcare (19%), industrials (17%) and utilities (13%) also receive heavy weightings, but financials get only 9%. Perhaps not surprisingly, its recent yield was just more than 1.2%. So, investors who desire a high yield will need to go elsewhere.
“However, the fund’s unusual makeup has enabled it to work just as a top equity income fund should: Parnassus Equity Income has generated superlative returns over time with lower risk. Ahlsten’s prescient move to reduce the portfolio’s exposure to financials in 2008 saw Parnassus Equity Income drop only 23% that year, and heavy exposure to technology stocks helped it beat the market in 2009 with a gain of 28.8%. The fund’s 10- year annualized return of 6.1% towers over not only the broader market but the average equity income fund as well. We think the fund’s strong performance merits the attention of investors whether they are attracted by its progressive mandate or not.”
Mark Salzinger, No-Load Fund Investor
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Floating Rate Funds
Walter Frank, Editor of the Moneyletter, discusses floating rate funds and recommends two of his favorite.
“This issue we focus on floating rate funds, also referred to as bank loan funds. In an era when money market funds are yielding just about zero percent, the two floating rate funds reviewed here sport 30-day yields on either side of 3.5%. They are considered short-term funds, their prices fluctuate (unlike those of money funds), and they carry a higher credit risk. Recall that most bonds, issued by corporations or governments, have fixed interest rates that do not change for the life of the bond. The price performance of a bond is directly impacted by changing interest rates. If rates rise over the life of the bond, the bond price falls since rates offered on newer bonds are more attractive, and vice versa.
“In contrast, floating rate bonds have an interest rate that is changed periodically to keep it in line with an interest rate benchmark. Rates are adjusted every 30 to 90 days and are often pegged to LIBOR (London Interbank Offered Rate) plus an additional amount. LIBOR is a pricing mechanism for short-term bank lending and is heavily influenced by U.S. Federal Reserve interest rate targets. Because the rate resets so often, one of the advantages of floating rate bonds is that their prices are less affected by changing interest rates compared to longer-term bonds, and can be more attractive to investors when rates are rising.
“The floating rate funds’ investments are corporate debt generally rated below investment grade. Importantly, banks, not the companies themselves, originate these bonds. Still, they are typically below investment grade. That said, bank loans are ranked senior in the capital structure to corporate loans should there be a bankruptcy, and are often secured by the borrowing company’s collateral. Meanwhile, these securities can also be subject to liquidity risk—the risk that investors cannot buy and sell at their desired time and price because of limited trading. Liquidity and credit risk came to the forefront during the recent financial crisis. Worries over the economy and corporate health caused investors to dump riskier bonds. In addition, some owners of bank loans—especially hedge funds—had to unload their investments in an untimely manner to meet redemptions. According to Morningstar, the average floating rate fund lost 31% in 2008, worse even than the 25% average decline in junk bond funds. However, in the subsequent recovery, what was pounded the worst generally rebounded the strongest, and the average bank loan fund gained 42% in 2009.
“While these gains are unlikely to be repeated in the near future, well-managed floating rate funds can offer an attractive yield in many investors’ portfolios.
Eaton Vance Floating Rate A (EVBLX)
“This fund was in the middle of Morningstar’s bank loan category in 2008. It had a significant exposure to economically sensitive sectors, including automotive, building, lodging, gaming, media, and publishing, all of which took greater than market-average hits. However, lead manager Scott Page was confident that careful investment selection based on strong research would eventually be rewarded, and a 46.1% 2009 return landed the fund ahead of 70% of its peers. Page and co-manager Craig Russ invest in senior, secured floating-rate bank loans, primarily below investment grade. They focus on firms with strong cash flows and positive earnings. Plus they diversify the portfolio widely across issuers (434) and sectors, and also have about 15% of assets invested in European debt. The recent 30-day yield was 3.63%.
Fidelity Floating Rate High Income (FFRHX)
“Manager Christine McConnell takes a slightly different tack with this fund. Based on a top-down economic outlook, McConnell aims to pick loans that will perform well given the environment. She tries to capitalize on sector-specific opportunities, and will also scrutinize collateral and loan covenants to find attractively priced prospects. She often purchases larger issuers whose debt should be more liquid than smaller borrowers, and will let cash build if she’s worried about redemptions. The portfolio also holds straight junk bonds, and has about a 6% stake in foreign securities. The fund tends to be more conservative than many of its peers, and that was evident in 2008 when the fund topped its category with a –16.5% total return. In turn, it did not rebound as much as its average peer in 2009, with a 28.9% gain. The recent 30-day yield was 3.43%.”
Walter Frank, Moneyletter
