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Big Risks for Big Yield

Investors should be cautious when expanding their search for income.

The article was published in the September 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

It's not easy to find income out there. While interest rates have trended up in 2021, they remain at historically low levels, and investors may be widening their search for income. Although there is an array of "income"-tagged funds across Morningstar Categories, investors should proceed with caution. Each notch up in yield means greater risk. Some funds have the resources and strategies capable of effectively taking on those risks. And then there are these four funds with Morningstar Analyst Ratings of Negative.

The 4.79% 12-month yield of Salient Select Income KIFAX is enticing. However, a closer look at this preferred-stock fund's construction reveals a high level of sector, liquidity, and credit risk. Its portfolio allocates primarily to the preferred stocks of real estate firms with much of the remainder in real estate investment trusts. Thus, the fund courts significant sector risk compared with peers. And the fund's focus on real estate preferreds, which usually go unrated or hold high-yield ratings and trade infrequently, leads to greater credit and liquidity risk. Those risks were on full display in early 2020's coronavirus-driven sell-off when it lost 43.4% from peak to trough compared with the typical peer’s 28.2% tumble. Investors may be attracted by this fund's sizable yield, but its concentrated and risky portfolio should keep them searching.

Multisector bond funds have some robust yields, but again you need to tread carefully. Invesco Global Strategic Income OPSIX has a 2.60% 12-month yield, on the lower end compared with peers but above the yield for the Bloomberg U.S. Aggregate Bond Index. The fund's management roster has been plagued by turnover historically, and the current duo's supporting cast lacks sufficient depth. Pair that with a wide investment mandate, allowing for meaningful shifts across global fixed-income markets, and the prospects are bleak. The portfolio has meaningfully changed in recent years to favor non-U.S. developed- and emerging-markets corporates, sovereigns, and currencies versus U.S. investment-grade credit and leveraged loans, while in late 2020, its U.S. exposure shifted to its lowest allocation in a decade. Such flexibility to take on risk might be warranted for robust and stable teams, but not for this group.

If investors are looking for broader diversification across stocks and bonds, they may turn to multi-asset income strategies. Such mandates combine various income-producing assets to deliver an attractive yield. Lord Abbett Multi-Asset Income ISFAX has a lofty 3.41% 12-month yield. Yet, the portfolio has gotten riskier as the team has allocated more heavily to equities and gone further down the market-cap spectrum. Within the bond sleeve, the fund holds long-term weights of 15% in high-yield bonds and 5% in convertibles. The team adds an additional layer to the base allocations, implementing sizable tactical tilts to express its short-term macro views. This is a tough approach to consistently execute even with a well-resourced team, which this fund lacks given that its three comanagers have no dedicated analysts behind them. Altogether, the fund's construction and loose guardrails have generated solid returns but have come with outsize risk; its three-, five-, and 10-year risk-adjusted returns (as measured by Sharpe ratio) trail the category index.

For greater geographic diversification alongside income prospects, investors might find a few opportunities in the world-allocation category. Eaton Vance Global Income Builder EDIAX has delivered a 2.94% 12-month yield through its 60/40 split between an equity sleeve and high-yield bond strategy. The fund's construction provides little downside protection, though. The managers take on big country and sector overweight positions in the equity sleeve, while holding most of the bond exposure in below-investment-grade issues. Though the firm's high-yield team is strong, a group of five equity analysts is understaffed to support this fund's global approach. Overall, during periods of market stress, correlations across this fund's exposures tend to increase and cause it to lag versus peers that have sturdier ballasts within their bond sleeves.

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