In recent years the search for yield has left many investors feeling like travelers lost in the Kalahari desert, wandering in the blistering sun, canteen in hand, trying to find a place that can reliably provide more than a trickle of water. Every oasis seems to turn into a mirage, as investors rush into a class of high-yielding investments only to push the prices up–and the yields effectively down. In just the past few years the phenomenon has occurred with dividend stocks, REITs, and utilities shares.
One useful alternative: “income builder funds,” which invest in both dividend-paying equities and debt. These mutual funds have promised higher yields and better returns than bond-only funds, and for the most part they have delivered. That’s why last year more than $20 billion flowed into the funds, and investors are on pace to hit a similar mark this year.
The good news is that these funds don’t seem like the latest yield mirage. Given the continued uncertainty–particularly about when interest rates will rise–income builders are good vehicles for these unpredictable times. Their biggest advantage is flexibility. “Things can change pretty quickly,” says Ed Perks, manager of Franklin Income Fund. “When you have a really flexible mandate, you can take advantage of those positions.” For example, Pimco’s Dividend and Income Builder Fund has more than 90% invested in equities. Just a few years ago that number was 55%.
If interest rates do increase, which punishes dividend stocks, the funds can shift to bonds. And managers say they’re more attuned to pricing than many bond-only funds. “If you are just buying income and not paying attention to the valuations, you are probably taking on more risk than you bargained for,” says Brad Kinkelaar, head of the dividend team at Pimco.
The flexibility has paid off lately: Pimco’s Dividend and Income Builder Fund rose 13% last year and paid a 4% dividend. J.P. Morgan’s Income Builder Fund pays over 4% and was up 9% last year. The funds didn’t increase as much as the equity market. But they threw off more cash than a bond and still increased in value.
One key to their success: digging up hidden gems. In 2011, when Europe was at its shakiest, Pimco invested in Societa Iniziative Autostradali e Servizi, which controls toll roads in Italy. The stock has maintained a 6% yield, and its total return has been 100% during that time.
Depending on your view of the relative fates of stocks and bonds, you can select different funds. For example, Columbia Management expects double-digit dividend increases for S&P 500 stocks this year. That could benefit the Goldman Sachs Income Builder Fund, which has more than 55% of its portfolio in U.S. dividend stocks.
There is also opportunity abroad: Non-U.S. stocks with the highest dividend yields (average price/earnings ratio of 15.8) are cheaper than domestic counterparts (23.1), according to O’Shaughnessy Asset Management. Both Pimco’s Dividend and Income Builder and the American Funds’ Capital Income Builder could take advantage of growth in international dividend stocks, with about 40% of their portfolios in non-U.S. equities.
If you’re dubious about stocks this year, one bond-oriented income builder fund with a good record is Loomis Sayles Strategic Income Fund. It has only about 20% invested in equities. That stock position helped it outperform pure debt portfolios last year, says Morningstar’s Sarah Bush. But its strong bond base positions it well if bond yields rebound.
This story is from the June 30, 2014 issue of Fortune.
