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Build your own income fund

The banks make money on their monthly mutual funds. Investors can do it themselves,ROB CARRICK says

The big banks are making a killing by selling a deservedly popular kind of mutual fund you can easily replicate yourself at a lower cost.

Monthly income funds combine bonds, dividend-paying common stocks and income trusts into a package that spits out cash every month. Whether you're a senior looking to augment your income or any old investor who likes a reliable flow of cash, these funds are worth a look. Investors obviously agree because they have about $18-billion sitting in monthly income funds sold by the Big Six banks.

Before you jump on the bandwagon, consider the idea of creating your own monthly income fund. All you need are an on-line brokerage account and a degree of comfort with the idea of buying your own securities.

The benefit of buying yourself is that you'll be in a position to get higher returns from your income investments than the typical fund would provide. Imagine a portfolio that produces enough income trust distributions, bond interest payments and dividends over a year to yield 5 per cent. If you bought this portfolio yourself, then that yield is what you receive.

But if you owned this portfolio through a monthly income fund run by a bank or other fund company, then your yield could be reduced by anywhere from 1.2 to almost 2.5 percentage points by fees that cover the fund's operating costs. Investors who lack the time, interest or expertise to assemble their own income fund may find these fees to be a good value, so don't read this as a criticism of the fund approach. But it has to be stressed that if you can do it yourself, you'll be in a position to reap higher returns.

You'll also face a higher level of risk -- let's be clear about that. A monthly income fund run by a bank or other fund company might hold dozens of securities, thereby limiting the risk that a problem with any single bond, trust or stock will crimp your flow of cash. Do-it-yourselfers will want to hold a variety of securities, too, but it would be too expensive in terms of commissions and too time-consuming to maintain a huge portfolio.

Let's look at an example of a high-income portfolio with nine components -- three income trusts, three dividend stocks and three bonds. These securities were chosen for the sake of example and may not be right for your portfolio. Commission costs for assembling the portfolio would be moderate at about $200, which is based on fees at the typical on-line broker. The level of diversification isn't ideal with just nine securities, but we'll try to make that up by mixing in some reliable income producers.

The income trusts

The great thing about today's income trust market is that there's something for every level of risk tolerance. Energy trusts will be of interest if you're aggressively seeking income and are less concerned about safety, while real estate investment trusts, power-generating trusts and blue-chip businesses like Yellow Pages have lower yields but a higher degree of solidity.

For this exercise, we'll forgo volatile energy trusts and sacrifice the extra yield they would bring. Instead, we'll use three trusts that have been rated by Standard & Poor's as having a high degree of distribution stability.

Gaz Métro LP is the first and it's a quintessential example of a trust that offers safety at the expense of fat returns. The stability rating is SR-1, which is the best you can get (SR-7 is lowest), and S&P says its distribution profile is conservative. That means Gaz Métro is not squeezing every penny of cash flow to pay its distributions. The price you pay for this sturdiness is a yield of 6.1 per cent, which is a low but not a rock-bottom number in the trust world right now.

Our second trust is Macquarie Power Income Fund, which S&P sums up with a stability rating of SR-2. This trust is based on the operations of a single power-generating plant in Cardinal, Ont., which raises concerns about a lack of diversification. The counterargument is that the plant is run by Macquarie Group, an Australian investment bank that specializes in packaging global infrastructure projects for investors. Another plus is an attractive yield of 8.3 per cent.

The third trust is Amtelecom Income Fund, which provides phone and Internet services to rural Ontario communities. Amtelecom has received an S&P stability rating of SR-3 and yields 8.4 per cent.

The stocks

The focus here is on stocks with a dividend yield of 3 per cent or more (that's a premium over what one-year bonds and guaranteed investment certificates offer), and a record of increasing their dividends.

Bank stocks are a must in a dividend portfolio because they offer an unbeatable combination of safety, decent yield and growing monthly payouts. We'll go with Bank of Nova Scotia, which offers the second-highest yield among the Big Five banks.

Canadian Utilities Ltd. is our second dividend play because of its stellar record of dividend boosts in recent years and its current yield of 3 per cent. Last, we'll go with a sin stock, Rothmans Inc., which has been handing cash to its shareholders by the shovelful lately and offers a yield of 4.7 per cent. The firm raised its dividend by 20 per cent in March and then handed out a special $1.50-a-share dividend in June.

The bonds

To lay a solid foundation for the bond part of this portfolio, let's use an exchange-traded fund that offers a proxy for the entire Canadian bond market, including government and corporate bonds. It's called the iUnits Canadian Bond Broad Market Index Fund and it offers a yield of about 3.6 per cent these days. Bonds pay interest twice annually, but this ETF offers quarterly payouts.

Government bonds offer almost 100-per-cent certainty that you'll receive your interest, but their returns are a little less than riskier corporate bonds. For this exercise, let's go with the higher returns of corporate bonds. The first is a Wells Fargo bond paying 4.38 per cent until June 30, 2015, and the second is a General Motors Acceptance Corp. Canada bond paying 5.75 per cent a year and maturing on Sept. 24, 2007.

Wells Fargo bonds are considered of good enough quality for pension funds to own them, but the GMAC bonds are lower down on the quality scale because of concerns about the health of parent GM.

Putting it all together

If you plan to withdraw the cash generated by your income portfolio each month, make sure you have a steady flow of dividends, interest and trust distributions throughout the year. This model portfolio would take in fresh cash each month, but March, June, September and December would see higher payments than other months.

In non-registered portfolios, you'll want to consider the tax profile of the various securities you buy. Bond interest is taxed as straight income, which means you pay the highest amount of tax on the most reliable source of income in your portfolio.

Dividends benefit from the dividend tax credit, while trust distributions are all over the map. If you want to minimize taxes, look at trusts with distributions that are partly a return of capital.

Go with the flow

Here' s a blend of income trusts, dividend stocks and bonds that can produce a flow of income in the same way as monthly income mutual funds, but without the ongoing management fees that lower returns. Approximately $10,000 was invested in each of the nine securities at midweek prices.

Income trusts

450 Gaz Metro LP $22.17 $9,977 6.10%$609
850 Macquarie Power Income Fund$11.38 $9,673 8.40%$813
720 Amtelecom Income Fund$14.30 $10,296 8.40%$865

Dividend-paying common shares

250 Bank of Nova Scotia $40.53 $10,132 3.40%$345
280 Canadian Utilities$35.65 $9,982 3.10%$309
400 Rothmans $25.52 $10,208 4.70%$480


335 iUnits Cdn. Bond Broad Market Index Fund $29.83 $9,993 3.60%$360
Wells Fargo 4.38% maturing June 30, 2015$101.31 $10,131 4.20%$438
GMAC Canada 5.75% maturing Sept. 24, 2007$99.87 $9,987 5.80%$575


© 2007 The Globe and Mail. All rights reserved.

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