Income Funds Demystified (2024)

Wouldn’t it be great if an investment would pay you an annual return just for owning it?

Welcome to the world of income funds. Similar to a guaranteed investment certificate (GIC) or bond—investments with which you accumulate interest every year—an income fund actually pays you a distribution yield. This means that every year you can expect to receive regular payments from the fund as a percentage of your holdings. In fact, many income funds pay a stable monthly or quarterly distribution.

It’s important to know, however, that unlike GICs, income fund distributions are not guaranteed and can change at any time.

Who should consider income funds?

Income funds may make sense for you if you’re interested in withdrawing capital from a diversified portfolio. They also provide unique tax-deferral benefits in non-registered accounts.

Here are three things to consider that can help you choose from the dozens of income funds available.

1. Look past the current yield

It’s tempting to find out which income fund offers the highest monthly or quarterly yield and pick that one. But yields don’t tell the whole story when it comes to income funds.

Income funds can be structured to pay out almost any yield through return of capital (ROC) distributions. An ROC distribution generally means that a fund pays out more than it earns in dividends, interest income and capital gains. The key benefit of ROC distributions is that they are not taxed in the year received. This provides a tax deferral benefit when compared to regular systematic withdrawal plans where each sale results in a capital gain (or loss) in taxable accounts.

Since a fund can be set up to pay any amount of ROC distributions, you can’t draw meaningful conclusions about the quality, risk profile or suitability of a fund based on yield alone.

For example, a fund with an 8% yield made possible through a high ROC distribution could be identical to a fund that pays 4% with no ROC. Or, the two could be completely different. In either case, the yield doesn’t tell you much about the fund at all.We suggest looking past the yield to focus on asset mix and the components of the distribution.

2. Review asset mix and distribution breakdown

When choosing an income fund, it’s helpful to understand the risk profile of the fund and where the distributions come from (including how much comes from ROC).

It's equally important to consider how sustainable the current distribution rate is based on expected interest rates and equity market returns. In an environment of decreasing interest rates or lower equity market returns, it would be difficult for funds to continue paying the same distribution since interest payments would decrease and capital gains would decrease or even turn to losses. In order to maintain the current distribution, the fund may have to invest in lower quality fixed income issuers, move to more risky asset classes or pay out more ROC. Remember that the fund manager is bound by the prospectus and its stated investment objectives. There is a limit to the changes he or she could bring to maintain a certain distribution.

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To understand a fund's risk profile, it’s important to look at its underlying exposure to equities (including income trusts and high-yield bonds), fixed income and cash. This is easily done through a quick visit to fund company websites or by looking at aDetailed Quotefor a fund. You might be surprised by the wide range of asset mixes in what, at first, appear to be similar funds.

3. Evaluate investment strategy and management quality

The strategy behind an investment and the way it’s managed are important factors to consider when shopping for any investment, including income funds. Pay particular attention to how the equity portion of a fund is managed because this component will likely have the biggest effect on long-term results. Comparing the fund’s investment objective to the current holdings is a great way to evaluate its quality. For example, you may want to see if the sector and geographical diversification fit with the stated objective. Another area to look out for is if the fund is highly invested in one specific asset, or if the risk is spread out among many stocks.

The key items to consider are the investment style, management experience and tenure, past performance record, analytical and other resources available to help manage the fund, fees, portfolio turnover, and assets under management.

This information is normally part of the “management bio”. Look at the manager’s tenure with the firm, their credentials and the areas of investing they have the most experience. Have they been with the firm for a long time? Do they hold a professional designation? Are they focused on specific strategies or are they specialized in a specific asset class?

A simple internet search will provide additional details since fund managers often have a personal webpage. Other sites such as Morningstar.ca provide compiled information for easy reference including the other funds they manage and past performance.

For many investors, income funds are part of a well-rounded portfolio. When you understand how they work and the differences between them, you’ll be on your way to making smart financial choices.

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