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Know your monthly income fund
Mutual funds with regular monthly distributions have become popular in recent years. Three of the bigger examples in this category are RBC Monthly Income, TD Monthly Income and BMO Monthly Income.
But the distributions paid by monthly income funds are only targets and some issuers may set their targets unsustainably high to attract inflows from investors. Distribution cuts can be bad news if the recipient is depending on a regular stream of investment income to fund living expenses. For them, it’s especially a good idea to do some homework before buying.
The first step is to have a good understanding of how the funds function. I like the explanation offered byKen Hawkins from Weigh House Investor Service: they are balanced funds with systematic withdrawal plans. The income received is a combination of dividends, interest payments, realized capital gains — AND return of capital.
A fund with a high distribution quite likely won’t be able to cover it with dividends and interest, so it may finance the gap with a large return-of-capital component. This can eat into the fund’s capital base over time , which may compel management at some point to cut the distribution or shift to more risky, higher yielding securities. Temporary reprieves may come in the form of strong gains in stock markets.
The second step is to calculate the distribution yield and compare it against the fund’s portfolio to see if they are supportable.
Let’s use the example of a monthly income fund with a rather aggressive yield: BMO Monthly Income. Its monthly distribution of $0.06 per unit yields about 8.8% annually at current prices. Add in the fund’s expense ratio of 1.49%, and its portfolio has to earn at least 10.3% per year to cover the distribution.
That seems kind of rich for a balanced fund with about 53% allocated to Canadian equities, 44% to fixed-income and 3% to cash. While the equity component may possibly earn 10.3% annually over the next ten years, it’s hard to see the other 47% of the portfolio earning that much. Going by historical rates of return, it might be closer to 5% to 7% — even with the corporate and provincial bonds in its portfolio.
That should leave a short fall of 1.5% to 2.5%. And that would be a rather best-case scenario. Historically, the fund has earned about 5.5% per year since inception in 1999. If that trend continues, the short fall would be closer to 5%.
But distributions can look unsustainable for a long time. Morningstar Canada, for example, warned of BMO Monthly Income fund’s distribution back in August of 2006, then in October of 2008 and then in Jan of 2010. How much longer can it hold up?
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