How do I Choose the Best Interest Income Fund?

When investors choose an interest income fund such as a bond mutual fund, selecting criteria might include the yield level of the fund's bond holdings, any future change in bond values, the fund costs and fees and any tax effects on interest income. Income investment is primarily concerned with receiving periodic income payments. Total investment return, however, can be further affected by potential changes in the fund's underlying bond values, fees charged by fund management and any taxes paid on interest earned.

Investors interested in income investment might choose an interest income fund that invests in investment-grade corporate bonds that pay interest higher than yield on the safer government debt while also preserving investment principal. Depending on individual investors' risk tolerance, income investment can also aim at bond funds that invest in high-yield securities known as junk bonds. In exchange for higher interest income, investors bear a larger potential default risk.

Emerging-market bonds and certain bank loans also pay higher yields than investment-grade corporate bonds. An interest income fund that invests in emerging-market bonds can be the choice for some income investors who also look to diversify into foreign markets. Some income funds might invest in a niche category of bank loans that pay higher yields comparable to those from junk-rated bonds but with specific assets as collateral. Another upside from an interest income fund with bank-loan holdings is that their interest is normally paid on a variable-rate basis, which works out the best in a rising interest-rate environment.

The value of an interest income fund likely fluctuates over time as prices of the bonds in the fund change in response to changing market interest rates. A decline in the fund value when investors sell their fund shares amounts to capital losses. This cuts into total investment returns despite a satisfactory level of interest income.

For income securities, the longer their maturity terms are, the more sensitive their market price to a given interest rate change. This means that there would be a larger price increase or decrease than that for securities with shorter maturities. In a rate-rising market condition, for example, investors are better off investing in shorter-term bond funds whose value would decline the smallest when an increase in interest rate causes all bonds to drop in value.

Fund management fees should also be one of the main factors to consider when choosing an interest income fund. Income investment normally does not expect a high degree of capital appreciation compared with equity investment. Any additional fund charges would have to be absorbed directly by interest income, lowering total investment returns. To boost investment returns, investors might also want to look into funds that have a portion of their holdings invested in certain municipal bonds, because the interest earned might be exempt from certain taxes.