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By Jason Stipp | 12-08-2010 06:00 AM

Fund Investors: Don't Favor Income at Any Cost

Income-oriented fund investors seem to be taking on significantly more risk for not much more yield, says Morningstar's Ryan Leggio.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Ideas Week on Morningstar.com, and today we're talking about income investing, specifically in the mutual fund arena. I am here with fund analyst Ryan Leggio. He is here to tell me a little bit about where mutual fund income investors are placing their bets and what their expectations should be.

Thanks for joining me, Ryan.

Ryan Leggio: Thanks for having me.

Stipp: So, the first question for you. We do have mutual fund flow data. We can see where investors are putting their fund dollars to work. What is that trend telling you, as far as where income investors might be placing their bets?

Leggio: Sure, so really all of this year we have been seeing dramatic inflows into bond categories, that includes the investment grade corporate bonds, multi-sector bonds, world bond categories really up and down the list. And to the extent that individuals are taking money out of their money market funds or CDs, we're seeing the dramatic flow into riskier fixed income investments.

Stipp: Certainly, the Fed's policy has been partially wanting to push people out of their cash investments into riskier investments, and I think that the zero percent or close to zero percent people are getting in saving accounts are one of those reasons.

But what should investors keep in mind, if they are taking money out of money markets and moving into bonds. I mean bonds historically are a pretty safe asset class, but it's also a low interest rate environment. What should I be thinking about on that front?

Leggio: Well, investors, I think should be thinking about, is this the type of risk that I really want to be taking on with my safe haven money--the money that used to be in money market funds, the money that would never go down in principal.

Investors need to understand that, one, they are not getting that much higher yields in short government or short credit bond funds. And two, they are taking on significantly more risk because not only are the yields low, but if interest rates do rise while you are in these funds, you could see your principal value go down. And I am not sure all investors who have moved money from money market funds to these bond categories really understand those risks.

Stipp: Certainly, interest rates have been low for a while, but they can't go down much further and likely at some point, they will start to go up.

So, can you talk a little bit about then, what is the risk/reward trade-off that we're seeing across some different durations? So, rates still are pretty low and to get a decent rate, you have to go into maybe longer-term bonds, for example. You mentioned that you're not really getting paid for that. What are you seeing on that front?

Leggio: So, in longer term bonds, the 30-year bond is now yielding about 4.3%, but you are taking on significant amounts of interest rates risk to get that 4% yield. And you have to remember just a few years ago, you were able to get 6%-7% yields by taking on the similar amount of interest rate risk. So, you're really not getting that much income for the considerable amount of interest rate risk you are taking.

Then move along all the way down to the short end of the spectrum. In a lot of our short government bond funds, you actually have negative yields, because the yields are so low on short government paper and the management fees are eating into those yields that you are actually probably better off in your money market fund that's yielding zero or 0.05%. So kind of on both ends of the spectrum, you're not seeing great risk/return trade-offs right now.

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