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Fund Investors: Don't Favor Income at Any Cost

Jason Stipp

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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Stipp: You mentioned to me earlier that, certainly yield is one of the reasons that investors go into fixed income, but there is also a certain stability to this asset class, which is another thing to keep in mind, and certainly people want fixed income as part of a long-term strategic portfolio plan.

So given that and given that you might want to be in fixed income even if the shorter term prospects aren't that great, what kinds of funds should you look for to make sure that even if you're going into these asset classes and putting some money to work, you're getting the best possible expectations that you can get.

Leggio: So I think you really hit on it, and that is, your fixed income slice your portfolio for a lot of investors. It is not just to provide income; it's also to be that ballast in your portfolio that, when the markets are rough or when certain asset classes do get really cheap, you do have some money that is still there for you to dollar-cost average in and buy those securities.

So I think, in your fixed income portfolio right now, diversification is really the big keyword. You really do want to be diversified across the different asset classes in fixed income, and then secondly, possibly taking on a little bit less risk. Now, yes, that does mean less yield at the same time, but maybe to wait until the yield opportunities in the risk/return trade-offs are better in the future. So those two things, diversification and maybe waiting for better opportunities are kind of the two hallmarks, I think, I would point to fixed income investors to right now.

Stipp: For some of those core funds, are there any specific ideas, any funds that you like or any traits that you like in finding a good bond fund?

Leggio: Sure. Well, investors can always go to our Fund Analyst Pick pages for the different categories.

But one I guess I would highlight for an investor who really is looking for yield, even though they really should be looking into the total return perspective for the funds, but we can get into that later, is the Vanguard High-Yield Fund; it's one of our picks. High yields have come down considerably this year. They started the year at about 9%. They are down to about 7.5%--so good but not great.

Then also the yield spreads, the spread between high yield and Treasuries, are about at a historical average. So, again, not a great margin of safety. But again if you want to be in an area where you get a decent amount of yield, that pick makes sense because you get seasoned management, extremely low fees that Vanguard is known for, and if you realize that that fund can be very, very volatile because it's a high yield fund, and can stick with it, then that's certainly a pick worth considering.

Stipp: So certainly, if nothing looks like a screaming buy, you want to be in a fund that's going to have reasonable expenses and reasonable expectations on that front so that you can make sure to at least maximize the opportunity that is out there right now.

Another area that I think investors are looking to try to pick up some income is dividend-focused funds, and you folks look at a lot of those funds. What are some of the traits on dividend-focused funds that you might look for, and what are you thinking as far as what the expectation should be in that arena as far as market expectations and possible future performance?

Leggio: Sure, so even more than with fixed income funds, you want to look at your dividend-focused equity funds as a total return vehicle, because over time you've gotten about half of your returns from the dividend yield and half from the capital appreciation. So if you're getting the dividend yield of 2% or 3% but you lose 2% or 3% in one year, you really haven't done yourself any favors.

From that perspective, dividend yields also, like fixed income yields, are at historic lows. The S&P 500's dividend yield is hovering right around 2%, and to give investor some perspective, in March 2009, it was above 3.5%. And before the credit crisis and everything at the end of 2007, it was also right around 2%, so we know what can happen when yields are around 2%.

For those investors who are interested in income opportunities, we've heard a lot about the dividend yields of blue chips being higher than their 10-year bond yields. They have to realize they are taking on significantly more risk to get the yields now than they could have gotten a year ago.

Again, if you want to be in these types of dividend-yielding funds, look for low expenses and for equities that are generally either fairly valued or kind of moderately cheap. If you look at our fair valuation graph, our equity analyst think wide moat stocks, which also happen to pay great dividends, are kind of fairly valued right now. Again, not a great margin of safety, but if you want to go there – funds like the Vanguard Dividend Appreciation Fund, there is an ETF version our ETF analysts like, VIG, and then the fund version; that's certainly an opportunity for investors, but again significant risks.

Stipp: You mentioned this a couple of times, Ryan, and you talked about taking on a total return approach, and I think a lot of retired investors historically have thought, I have a portfolio with a principal value and then income is thrown off from that, and I live off the income--I don't touch the principal. And when you say total return approach, that seems counter to that historical way of thinking about a portfolio, but why, again, can you say why is a total return approach especially in today's environment such an important thing to consider?

Leggio: Well, I think investors need to step back and realize that a big part of their fixed income returns over the last 10 or 20 years hasn't just been the yield but has been the appreciation of their bond funds because inflation and interest rates have kind of steadily marched downward.

Well, fast forward to where we are now: Yields are near historic lows, and if we have yields slowly marching upwards, then it's that total return, it's the yield plus capital appreciation. We know what the yield is, which in various categories is between 2% and 4%, and the capital appreciation part, there really isn't any if yields start going up. So, investors need to realize that they are really kind of stuck with the yields of their portfolio being their total return going forward.

Stipp: So, certainly important to take a broader look at your portfolio and where some of that income could come from and where you might get capital appreciation and undervalued assets to potentially feed a possible income stream in the future.

Leggio: One category I'd highlight right now is the high-yield category, which is up over 10% this year. We're seeing a lot of those funds trade above par. That is, they are trading at 1.01 or 1.02 and so you really don't have that opportunity for capital appreciation at that point, so investors really need to be cognizant of those risks.

Stipp: Well, some great ideas, Ryan, some great recommendations. Thanks, so much for joining me today.

Leggio: Thanks for having me.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.