Understanding Distribution of Income by Unit Trust Funds
A unit trust fund distributes income to its investors in line with its declared distribution policy. Generally, fixed income/bond funds pay distributions to their investors on a regular basis, while distributions declared by equity funds may vary with market conditions.
To understand the underlying mechanism of income distributions by unit trust funds, it is useful to know that equity funds and fixed income/bond funds derive their income for distributions from different sources, as illustrated below:
1. Breakdown of Income Distribution for Equity Funds
Based on the Securities Commission’s guidelines on unit trust funds, distribution of income can only be declared from realised income. For equity funds, realised income comprises capital gains and dividend income. Capital gains are generated when the fund sells its investments that have appreciated in value, while dividend income is earned from the fund’s holdings of companies’ shares.
Chart 1: Income Components of Equity Funds
In any particular year, the distribution of income by equity funds depends on the impact of market conditions on the funds’ realised income for the year concerned.
When the market is in an uptrend, equity funds are capable of generating a higher quantum of capital gains. The funds may also receive higher dividends paid by investee companies due to the latter’s stronger corporate earnings. Equity funds are therefore more able to declare higher distribution of income when market conditions are favourable.
In contrast, when the market is in a downtrend, equity funds generally have a lower quantum of income for distribution purposes due to lower capital gains generated. Challenging market conditions may also lead to weaker corporate earnings, prompting companies to reduce dividends in order to conserve their cash flow. This could affect the dividend income received by equity funds and in turn, their ability to declare distributions.
It is important to note that the distribution policy for most equity funds is incidental, which means that the funds do not pay out distributions on a regular basis. Instead, any distributions declared are subject to the availability of the funds’ realised income and/or gains in a particular year. During a market downturn, some equity funds may opt to reduce their distributions or not to declare any distributions at all.
2. Breakdown of Income Distribution for Fixed Income/Bond Funds
Fixed income/bond funds derive their income for distributions primarily from three sources:
i. Coupon payments from sovereign bonds and/or corporate bonds;
ii. Capital gains from selling bonds that have appreciated in value; and
iii. Interest income from deposit placements and money market instruments.
Chart 2: Income Components of Fixed Income/Bond Funds
Generally, fixed income/bond funds pay distributions to unitholders on a fixed schedule (semi-annually or annually). This is because bond issuers – usually government entities and corporations – are obliged to pay interest/coupon payments at fixed intervals as well as to repay the principal upon maturity of the bonds.
In addition, deposits placed with licensed financial institutions and money market instruments are low risk investments that provide stable interest income while preserving the nominal capital value. These features make fixed income/bond funds an appropriate choice for unit trust investors seeking to receive stable income.
However, it should be noted that capital gains of fixed income/bond funds are subject to interest rate movements. A rise in interest rates generally leads to a fall in bond prices, which could in turn impact capital gains generated by fixed income/bond funds. Conversely, when interest rates decline, bond prices appreciate and the funds are more able to generate a higher quantum of capital gains.
Hence, unit trust investors are advised to stay invested in the medium to long term to ride out the short-term volatility of the bond market, as fixed income/bond funds will be able to provide a steady and regular stream of income through coupon receipts and active portfolio management over time.
As mentioned earlier, given that the distribution of income payable by equity funds is subject to the market performance in a particular year, unit trust investors who require a quantum of income on a regular basis should ensure that their portfolios include fixed income/bond funds which provide semi-annual/annual income. The allocation of fixed income/bond funds in the portfolios should be higher if the investors’ requirement for distribution of income is more important.
By understanding the difference between equity funds and fixed income/bond funds in terms of income distributions, unit trust investors should be able to make better investment decisions by focusing on funds that are in line with their income needs and risk profiles. It is also important that investors adopt a medium- to long-term approach when investing in unit trust funds to ride through any short-term fluctuations in equity and bond markets.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.