If you own a monthly income fund, get out a can opener right now and pry it open.
Monthly income mutual fund and exchange-traded funds are a popular and efficient way to generate monthly investment income from bond interest and both common and preferred share dividends. These funds have been great products for income-seeking investors in recent years, but challenges lie ahead. Find out now how your monthly income funds might react by looking at what's inside.
The big issue is rising interest rates in the bond market. They're bad for bond prices (yields and prices move in the opposite direction), and they can also be negative for preferred shares, real estate investment trusts and dividend payers in sectors like utilities. Your homework assignment is to look into your monthly income funds to check on the mix of investments. You're basically doing a stress test to see what might happen if and when rates start to return to more normal levels.
Rates in the bond market have started to move higher in recent months as investors prepare for the possibility that the U.S. Federal Reserve will raise rates in September. If that happens and the U.S. economy gains strength, then we could finally see the long-awaited bounce off the interest rate lows that have prevailed since the financial crisis.
Let's take a quick look at two monthly income products to show how different mixes of holdings can produce different results. The iShares Diversified Monthly Income ETF (XTR-T) is two-thirds weighted to bonds, with the rest in stock market investments like preferred shares, REITs and dividend-paying common shares. Globeinvestor.com shows XTR shares have fallen 5.5 per cent in the past 12 months.
Now for the BMO Monthly Income ETF (ZMI), which has about 40 per cent of its assets in bonds and the rest in dividend stocks and preferred shares. ZMI shares are down 1.5 per cent in the past 12 months.
Don't make buy and sell decisions based on numbers like these. Use them to understand the implications of what your monthly income funds hold. A high bond weighting will protect nicely against recessions and stock market corrections, but be a burden if interest rates rise. A tilt toward stocks might help if rates rise, but you'll get hit harder if the stock market plunges. Also, watch the exposure to interest rate sensitive sectors like preferred shares. Yields are appealing in the preferred share market, but rising rates will sting.