written by: Ginny Edwards•edited by: Jason C. Chavis•updated: 6/21/2010
Should monthly income producing funds be part of your investment portfolio? Learn about the various types of monthly dividend paying funds and find out which ones are better under different market conditions.
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The first of the month can mean a lot of different things to people – a time to pay bills, set new goals, or plan a much-needed vacation. For investors with monthly income producing funds, it also means the time when they receive a little extra cash in the form of a dividend payment.
In a volatile market when quarterly dividends do not provide enough liquidity, monthly income producing funds enable investors to add some security and diversification to their portfolios. Because there are so many types of income funds, investors can hedge their risks by investing in tandem with what they believe will be the economic conditions going forward and if they think the bulls or bears will have the edge. For most investors, the best way to start receiving monthly dividends is through the purchase of mutual funds and ETFs.
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Corporate and Convertible Bond Funds for the Bull Market
Corporate bond funds invest in the debt securities issued by corporations and are often referred to as high-yield bonds because they pay a risk premium over conventional treasuries. One of the best times to own high-yield corporate bonds is during a recovery or the early expansion phase in the economic cycle, when GDP increases, consumer confidence rises, and credit begins to thaw. The worst time to own corporates is during a recession, when the leading indicators deteriorate and investors take off their risk trades. There are many corporate bond funds that pay monthly dividends. Principal High Yield A Load Waived (CPHYX.lw) is one with a proven five year track record and a current yield of 8.72%.
Convertible bond funds are an alternative for investors who have less conviction about the market's upward direction. These funds invest in convertible securities, which are corporate bonds that can be exchanged at some later time for common equity. Basically, they give investors a place to park their money while they wait for the market to takeoff. The trade-off is that they typically pay lower yields than standard corporate bonds because investors are paying a premium for the conversion option so they don't have to try to time the market themselves. Although most convertible bond funds and ETFs payout at quarterly intervals, there are few, such as the SPDR Barclays Capital Convertible Securities (CWB), which do offer monthly dividends.
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Government Obligations Bonds for the Bear Market
When fear grips the market and the bears are on the loose, the best place to hide is in the safety of government-backed obligation bonds. The flee to safety in United States government securities normally drives bond prices up and yields down, but overall increases total returns. Because the monthly income will fluctuate over time, they may not be right for investors dependent upon a fixed amount flowing in every month. If interest rates are expected to rise, short term government bond funds, such as the Eaton Vance Government Obligations (EVGOX), will be less sensitive to rising interest rates and will have more stable prices than bonds on the longer side of the yield curve.
Continue to page 2 to read about other types of monthly income producing funds and their potential rewards and risks.
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Rising interest rates and tax increases can deflate returns of most fixed income funds, but there are few monthly dividend paying funds that become more attractive in a rising rate environment or when tax increases find favor with lawmakers. Investing in bank loan funds is a defensive way to protect principal against the impact of rising interest rates and still get the benefits of a monthly dividend. Municipal bond funds also become more interesting as taxes increases lower returns of taxable income funds as long the risk of default by states and localities remains modest.
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Municipal Bond Funds - When the Tax Man Comes Knocking
The strongest reason to own municipal (muni) bond funds are the tax benefits that accrue to investors because most U.S. municipal bonds are exempt from federal taxes and also state and local taxes if the bonds are issued in the investor's state of residence. But some muni bonds are taxable, so you have to check the funds carefully and consult with your tax adviser if you have any questions. Muni bond funds can be national or state specific and of short, medium, or long term duration. Historically, the default risk of munis has been quite low, but this may change as states and localities contend with rising budget deficits and possibly underfunded pension plans that are based on generous assumptions about future rates of return. One interesting way to diversity the rising risk in munis is through an ETF recently launched by iShares, the S&P AMT-Free Municipal Series (MUAA-MUAF), that enables investors to create bond ladder munis with end dates ranging from 2012 to 2017.
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Bank Floating Rate Loan Funds as Interest Rates Climb
Rising interest rates can turn a bond portfolio into a severe underperformer, but there are monthly income producing funds, known as bank floating rate loan funds, that actually work well under these conditions. These funds are comprised of bank loans that are extended to corporations, are below investment quality and reset periodically (every 60 to 90 days). The rate of return on a floating rate loan is typically determined by LIBOR + the risk premium for the loan. However, investors need to be cautious in investing in bank loans whenever there is a contraction of credit or uncertainty in the financial sector, such as the possibility of regulatory reform. For investors considering this strategy, Eaton Vance Floating Rate Income Trust (EFT) is a solid choice within this class with a current yield of 6.33%.
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Reach for Yield With an Eye on Risk
While reaching for the highest yield is tempting, investors need to evaluate current market conditions to determine if there principal will be at greater risk. Wall Street Network also provides a fairly comprehensive list of monthly dividend paying stocks (ETFs) that you can download into an Excel spreadsheet to begin doing your analysis.
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Coleman, Murray, Floating-rate bond funds offer alternative to high-yield debt. MarketWatch. (April 23, 2007). MarketWatch - Stock Market Quotes, Business News, Financial News. Retrieved June 17, 2010, from http://www.marketwatch.com/story/floating-rate-bond-funds-offer-alternative-to-high-yield-debt
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