There are thousands of mutual funds for you to choose from, and most share the characteristics that have made them a popular investment: liquidity, diversification, and professional management. However, only certain mutual funds have a high dividend yield. Below, we take a look at how some mutual funds generate and distribute dividends.
Key Takeaways
- Mutual funds that own dividend-paying or interest-bearing securities pass those to investors in the fund.
- Dividends are the investor's part of a company’s profits. The company sets the amount based on its financial results.
- Interest is the payment to investors for lending money in the form of a bond or other debt instrument.
Dividend Mutual Funds
High-dividend-yield mutual funds appeal to those who prefer a consistent income. These funds invest in high-dividend stocks and high-coupon bonds to offer shareholders with this preference regular income year after year.
This income is paid as dividends representing the investor's part of the fund's earnings from all sources. Many funds are designed to avoid dividend-generating assets or interest-paying bonds to minimize any tax liability for their shareholders. They instead focus on finding stocks with rising prices instead of the steady but more modest dividend income. But even these funds could have dividend distributions.
Whatever the case, all mutual funds are required by law to distribute their accumulated dividends at least once a year. From there, though, the timing and other details can vary significantly for each mutual fund.
Understanding Dividends Paid from Mutual Funds
Firms often pass a part of their profits to shareholders as dividends. Shareholders receive a set amount for each share they hold.
For example, IBM paid a dividend of $1.66 per share on Sept. 9, 2023. The declaration date for that payment was July 24, 2023. Coca-Cola paid a dividend of 46 cents a share Oct. 2, 2023, and the declaration date for the dividend was July 19, 2023.
For a high-dividend-yield mutual fund, this income can constitute a major chunk of its returns. Growth-oriented mutual funds may earn modest dividends from a handful of holdings since they concentrate on other means of producing returns for investors.
Mutual fund investors may take dividend distributions when they are issued or reinvest the money by buying additional fund shares.
Mutual funds that receive dividends from their investments are required by law to pass them to their shareholders. The exact manner they choose to do so can differ. Mutual funds typically distribute dividends on a regular schedule, which can be monthly, quarterly, semiannually, or annually.
How Interest Payments Are Counted
A mutual fund may have a portfolio that includes dividend-bearing stocks, interest-bearing bonds, or both.
Mutual funds are required to pass on all net income to shareholders in the form of dividend payments, including interest earned by debt securities like corporate and government bonds, Treasury bills, and Treasury notes.
A bond typically pays a fixed interest rate each year, called the coupon payment. This is a percentage of the bond's face value. Unlike stock dividends, bond interest is guaranteed and the amount of the payment is established upfront.
When researching mutual funds, you should check if the historical returns shown on the fund fact sheet include the reinvestment of dividends. In other words, it's important to ensure that the reported returns are not inflated and reflect the total growth, including capital gains and dividend distributions.
Aggregation and Timing
Most companies that pay dividends on stocks typically do so quarterly. Some companies pay semiannually, while others issue dividends monthly.
Mutual funds collect these dividends as income and then distribute them to shareholders pro rata. All funds must legally distribute their accumulated dividends at least once a year. Those focused on producing continuous income for investors may pay dividends quarterly or even monthly. But most pay annually or semiannually to lower administrative costs.
Some mutual funds retain a portion of dividends from periods when dividend income is higher and then distribute these retained funds in periods with lower income. This is done to maintain consistency monthly despite the inevitable fluctuations in the fund’s dividend income.
Interest earned from fixed-income securities in the mutual fund’s portfolio is also pulled together and distributed to shareholders pro rata, which could appear on statements under dividend income.
Dividend Reinvestment
Some investors, especially those who are not retired, prefer to reinvest their dividends over receiving payouts. Making a dividend reinvestment plan with your mutual fund is easy enough. You simply notify your broker or the mutual fund to automatically reinvest any cash disbursed for additional shares.
Shareholders can also use their dividends to purchase a stake in a different fund. The fund company usually permits this as long as the second fund is within its family of products. Independent brokers and investment firms often do this, too, no matter which fund it is.
Tax Reporting and Share Price
Funds that pay dividends reduce their share prices by the amount of the dividend being paid on the ex-date in the same way as individual stocks.
For example, a fund with a share price of $10.42 that pays a dividend of $0.10 per share will trade at $10.32 on the ex-date. If you own shares before the ex-date, you will be paid this dividend. If not, then you won’t.
All dividends are treated as ordinary income in the year they are paid unless they involve an individual retirement account or tax-advantaged retirement plan. Mutual fund dividends are reported on Form 1099-DIV, like dividends from individual stocks.
The rules for reinvestment, aggregation, and price are also largely the same for master limited partnerships, real estate investment trusts, target-date funds, and exchange-traded funds when paying dividends.
Can I Reinvest Dividends From High-Dividend Mutual Funds?
Yes, many funds offer a dividend reinvestment plan allowing you to buy additional shares.
What Should I Consider When Choosing High-Dividend Investments?
Among other details, look for long-term earnings growth, strong cash flows, and a high dividend-coverage ratio, indicating that the company can cover its dividend payments.
What Is the Key Difference Between Interest Coupons and Share Dividends?
Interest coupons are mostly fixed payments made to bondholders, while share dividends can vary depending on the company's profits and dividend policy.
Do Mutual Funds Invest in Both Bonds and Shares?
Yes, mutual funds can invest in both bonds and shares simultaneously. This type of mutual fund is usually called a balanced or hybrid fund.
The Bottom Line
Mutual funds have different forms and strategies, and they can offer several benefits, such as liquidity, diversification, and professional management. High dividend yield mutual funds add another benefit by passing on dividends and interest from their portfolio securities to investors. These dividends are a part of a company's profits (accessed through equity exposure), while interest coupons are generally fixed-income payments for lending money through bonds or other debt instruments.
