Vanguard's best (and lesser) mutual funds for investors who need income

Happy New Year! Our gift to you: some Vanguard income-generating mutual funds to consider for 2018.

We hear from many readers desperate for income from their equity and bond portfolios, so we checked in for recommendations with Daniel Wiener, who, as editor of the Independent Adviser for Vanguard Investors newsletter, specializes in tracking our homegrown favorite.

Wellesley Income, which Vanguard launched in 1970, holds roughly 35 percent of its portfolio in bonds, while Wellington also pays investors a steady stream of income, according to Wiener and his coauthor, Jeff DeMaso, who are based in Brooklyn, N.Y. Vanguard expanded its income fund lineup to include STAR LifeStrategy Income, Target Retirement Income, and Managed Payout.

How do these stack up against Vanguard's High-Yield Corporate and High-Yield Tax-Exempt funds?

To compare, Wiener and DeMaso start with a $10,000 investment in each fund made at the end of June 2008 and running through September 2017. That time frame includes Vanguard's Managed Payout, which launched in 2008. They assumed a 20 percent tax rate for long-term gains and qualified dividends, and the top 43.4 percent tax rate on short-term gains and interest (see table).

"The two high-yield bond funds are difficult to beat if you are looking for income," DeMaso noted.

Vanguard High Yield Corporate is the winner "by a wide margin, and it's competitive even after taxes. Everyone's situation is different, but it's likely that if you are retired, you will not be in the highest tax bracket, and hence you'll keep more of the fund's payout," he added.

Longtime Vanguard mutual funds Wellington and Wellesley Income also deserve some kudos. "These funds have paid out a high level of income and grown $10,000 nicely over the same time period," Wiener said. Balanced Index has also grown the initial investment, "but didn't distribute anywhere near the same level of income."

Though billed as income funds, STAR LifeStrategy Income and Target Retirement Income "are near the bottom of the scoreboard. They delivered half the income of High-Yield Corporate and roughly as much as Balanced Index and Dividend Appreciation Index. With more than $26 billion in assets between them, these income solutions have been better for Vanguard than they've been for their investors."

Of Vanguard's newer income funds, Managed Payout has supplied a competitive level of income.

"But it's done so by returning your capital to you rather than generating it from its investments," DeMaso said. "Managed Payout reflects some of the newest thinking in portfolio construction and is a complicated portfolio for Vanguard to manage, employing hedge-fund-like strategies. It sounds impressive, but the results haven't been much, if any, better than the tried-and-true Wellesley Income and its bonds-plus-stocks strategy. High-Yield Corporate remains at the top of the heap for an investor looking to live off their income today."

For investors in high tax brackets, consider High-Yield Tax-Exempt. However, if you have a longer time horizon, it's important to also own some stocks.

Wiener is telling his investors that he's "leery of Vanguard's income funds, STAR LifeStrategy Income and Target Retirement Income, which have not delivered much income to investors. Given the investment-grade, government-bond-heavy index funds, don't expect these two funds to suddenly improve their payouts. Managed Payout has been competitive, but given its complexity and patchy history — remember, there were originally three Managed Payout funds that were merged into one — I'd still be cautious, particularly when an old classic like Wellesley Income has been just as effective without all the mumbo jumbo and returns of capital."

Other readers wrote in to ask whether municipal bonds have lost their tax-exempt status under the new tax law. They haven't.

"We came out of this as well as could be expected," said John Mousseau, director of fixed income with Cumberland Advisors. "We bought a lot of housing authority, universities, and hospital muni bonds" during a sell-off in the market in the lead-up to the tax bill's passage.

Cumberland is avoiding some state-issued New Jersey bonds because "it's in worse financial shape" than other states. The firm has been a buyer of Wisconsin and New Hampshire housing bonds, or non-state credits such as Bergen or Gloucester County bonds.

What about Treasuries?

"Our Federal Reserve is now raising short-term interest rates and starting to reduce its balance sheet, while in Europe the central bank is still in easing mode," Mousseau said. Sovereign wealth funds remain buyers of U.S. Treasuries, buoying the market.

"Down the road, when the Fed and the European Central Bank are on the same page and both stop easing, then it might be time for higher yields" and lower Treasury prices, he added.