When you invest in a bond mutual fund, you expect to earn income. How much you earn depends largely on the degree of risk that the fund carries: The longer the maturity and the lower the credit quality of the bonds in the fund's portfolio, the higher your income.
You generally can't rely on a bond fund for capital appreciation unless we're in a period, such as the current one, in which interest rates fall and bond prices rise. But the beginnings of those periods are unpredictable, and their endings always come too soon.
When you invest in a well-managed equity fund, however, you can expect gratifying appreciation over time, but your dividends are likely to be less generous than those of a bond fund.
If you want good income and moderate appreciation, you may wish to look at some of the funds classified by Lipper Analytical Services as flexible income funds. With income as their principal objective and capital preservation and appreciation as additional goals, most invest in both bonds and dividend-paying stocks. (T. Rowe Price's new Spectrum Income Fund invests in other Price funds that own them.)
The funds' investment policies commonly give their portfolio managers the flexibility to switch among asset types. Some are more flexible than others.
The most significant differences in the performance of the group's leaders (see table) are attributable to the types of securities in which the funds invested. But annual operating expenses have been important, too.
Fees have ranged from about 0.5 percent of average net assets for two of the group's no-load funds, USAA Income Fund and Vanguard's Wellesley Income Fund, to around 2 percent for Advest's Advantage Income Fund and the Class B shares of PaineWebber Income Fund. All things being equal, such a spread can account for a gap of as much as 1.5 percent in yields and total returns.
Of course, all things are not always equal. Being invested in different mixes of securities, some funds offer their shareholders higher rewards -- and risks -- than others.
John P. Doney, portfolio manager of National Total Income Fund, the leading performer, likes to be about 60 percent invested in common stocks. But he drops below that ratio when he can't find enough to meet his criteria (including a yield of at least 4 percent). Now is one of those times; stocks currently make up just under 50 percent of fund assets. Doney is about 45 percent invested in bonds but, leery of credit risk, he holds 35 percent in U.S. Treasury and other government securities. "They're also more liquid," he notes .
Eugenia M. Simpson has tended to keep about 70 percent of Mutual of Omaha Income Fund in bonds -- nearly all investment-grade corporates -- and about 20 percent in stocks. "I wouldn't be surprised," she says, "to see the equity portion increase. At this point, stocks offer a better reward-risk ratio than they've offered in some time."
In managing USAA Income Fund, John W. Saunders Jr. has maintained a roughly 80-20 bond-stock mix, but with nearly 70 percent in government-related, mortgage-backed securities. The stocks are those of high-yield electric utilities.
Wellesley Income Fund -- the largest flexible income fund, with $1.6 billion in assets -- has about 60 percent in bonds and 35 percent to 40 percent in stocks. Earl E. McEvoy, who runs the bond portfolio, has invested the largest share in investment-grade corporates and the balance in Treasury, mortgage-backed and other government securities. He raised the share of corporate bonds this year as the spread widened between their yields and those of government bonds.
John R. Ryan, who manages Wellesley's equity portfolio, uses stocks whose price-earnings ratios are lower than that of the Standard & Poor's 500 Index, whose dividend yields are higher than the index's, and whose dividends are likely to be increased. This strategy has led him to concentrate in electric utility and telephone stocks and, in recent months, to add significantly to his energy holdings.
J. Paul Rodriguez, portfolio manager of Seligman Income Fund, has taken a different approach: a 50 percent stake in convertible bonds and preferred stocks. His strong 1991 showing reflects recovery from a poor 1990, when convertibles were hammered down, and his decision to stay with them. "I believed in what I was doing," he says. His holdings of nonconvertible bonds -- over 20 percent of assets -- are of investment grade because "I decided not to take a risk in that area."
Which is just what Albert O. Nicholas and Ernest E. Monrad have done. Nicholas Income Fund and Monrad's Northeast Investors Trust are primarily invested in "junk bonds" -- mostly better-class junk.
Northeast takes even greater risks by borrowing money from banks so it can invest more than the cash it raises through share sales. In 1991, as the junk bond market staged a strong recovery, Monrad lifted the trust's debt to $50 million -- more than one-tenth of its gross assets -- because of the opportunities he saw to earn 15 percent to 20 percent on money borrowed at 9 percent to 10 percent. He says: "I got greedy."