2 Income-Producing Funds We Like

Christine Benz: Hi, I'm Christine Benz for Morningstar. Many investors are perennially on the hunt for yield, but that search has gotten harder in recent months. Joining me to discuss what income-seekers should bear in mind and to share a few favorite income-producing funds is Alex Bryan. He's Morningstar's director of passive strategies research for North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about some of the factors that have driven down yields across the board in recent months.

Bryan: Well, interest rates are near historic lows, and that depresses the yields and expected returns of nearly all investments. So, there really is no escaping low interest rates. No matter where you look, expected returns and yields are really being depressed.

Benz: Alex, many investors, as you know, are attracted to generating income from their investments. Can you share any tips that they should bear in mind if they are on the hunt for income in what is quite a yield-constrained world today?

Bryan: Ideally, the fund should have some risk controls in place, and this can be achieved either with funds that are screening for both yield as well as some measure of quality, or through funds that are using a broadly diversified portfolio where a few bad apples aren't necessarily going to derail your investment performance. But it's important to really keep an eye on risk because that can creep into your portfolio when you're hunting for yield.

Benz: You and the team focus on passive strategies, ETFs, and index funds. So, you brought a few funds that you like that you think do do a good job of generating income and also managing risk. Let's start with a bond fund that you and the team like. One you like is iShares Broad USD Investment Grade Corporate Bond. The ticker is USIG. Talk about what you think its attractive attributes are.

Bryan: With bonds, I think, you really can keep it simple and stick to broadly diversified investment-grade corporate bond funds like the iShares Broad USD Investment Grade Corporate Bond fund that you mentioned. Investment-grade corporate bonds tend to offer higher yields than Treasuries and agency mortgage-backed securities, which really account for the bulk of the U.S. investment-grade market. But they still have fairly low credit risk and effectively diversify stock risk. So, this particular fund is offering very broad exposure to investment-grade corporate U.S. bonds. So, it basically owns pretty much all corporate bond issuers out there with at least one year to maturity and then weights them based on market value.

So, there isn't a lot of exposure to issuer-specific risk. You get a very broadly diversified portfolio. And that simple screen for investment-grade bonds goes a long way to keeping risk in check. Because these bonds, while they have more credit risk than Treasuries, for example, they still have very strong balance sheets and are very likely to be able to repay their debt. So, I think it's just keeping it really simple. Focusing on investment-grade bonds is a great way of keeping risk in check with respect to your fixed-income investments.

Benz: Would this be a fund that someone would use as a stand-alone fixed-income fund, or would they want to augment it with a fund that encompasses government bonds and other sectors that are left out here?

Bryan: I think this is best used as a satellite or a supplemental holding to a core bond fund that includes Treasuries and agency mortgage-backed securities. But if you're looking to boost your yield a little bit, I think it's a good strategy to overweight corporate bonds. Because corporate bonds, if you're just sticking to a broad Bloomberg Barclays Aggregate Bond tracker, corporate bonds only represent a small fraction of that portfolio. So, if you overweight corporate bonds by pairing one of those aggregate bond trackers with a corporate bond fund like this, I think that's a good way to boost your yield without taking an excessive amount of risk.

Benz: Now, let's look at equities. One fund that you and the team like is Vanguard High Dividend Yield Index. The ticker is VYM. Talk about why you like that one.

Bryan: This fund offers very broadly diversified exposure to high-dividend-yielding stocks. So, it basically targets stocks of all sizes, U.S. stocks of all sizes, that represent the higher-yielding half of all U.S. dividend-payers and then it weights them based on market capitalization. So, the way that this fund keeps risk in check is through broad diversification and through market-cap weighting. So, it will still own a few bad apples, some stocks that may not be able to sustain their high dividend payments, but those tend to represent a very small part of the portfolio, because if a stock in fact does have deteriorating fundamentals, the market capitalizations tend to be small to begin with and they often become smaller as those stocks disappoint. As market capitalizations of weaker companies shrink, they become a smaller part of the portfolio. So, this fund is really doing a good job of delivering a higher dividend yield than the market while still not putting all of its eggs at any one basket or any one sector. I think it does a really good job of effectively diversifying risk. It's been one of the harder dividend income funds to beat. It's one of the cheapest funds in that group. So, I think those characteristics really make this particular fund very attractive, and it's certainly one of our favorites when it comes to generating income with your equity portfolio.

Benz: And how about the portfolio context here, Alex? Is this something that would be a worthy stand-alone holding? Or should investors also augment it with a total market exposure fund?

Bryan: I think this one could serve as a stand-alone holding because if you look at the risk of this portfolio, it actually tends to be a bit more defensive than a total stock market fund. So, it tends to hold up better than the market during downturns and you do give up a little bit of upside during market rallies, but I think this is a really great option for investors who are looking to boost yield because you also get the benefit of lower risk than the market. So, this is a really good option as a core stand-alone equity holding. It doesn't have a lot of exposure to individual stocks or individual sectors. So, I think it's sufficiently well-diversified that it could serve as a core portfolio building block.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.