Income investing

Investing is a great way to grow your wealth over time, pretty much as you sleep. But what if you want to see returns on your investments sooner? This is where investing for income comes in. Income investing is an investment strategy that is centred around building an investment portfolio that aims to generate a regular and, crucially, passive income stream.

If you don’t find a way to make money while you sleep, you will work until you die.

Warren Buffett

Income-paying asset classes

Equities

One of the most common ways to get a regular income is to invest in dividend-paying stocks, i.e. companies that pay a proportion of their profits out to shareholders on a regular basis (typically annually or quarterly). One of the key metrics here is the dividend yield, which is calculated by dividing the annual dividend amount by the company’s share price. As an income investor, you want to invest in companies that generate a high and/or sustainable yield.

Bonds

Bonds is also referred to as fixed income, and so it is no surprise that it is another option for an income-seeking investor. Bonds pay interest on a regular basis in the form of a coupon and just like with dividend-paying stocks or equities, the return on the bond is the yield. There are different types of yields for bonds, but that is for another day. The yield is also dependent on the type of bonds you invest in, with investment-grade bonds typically offering lower yields than high-yield bonds.

Property

The third major asset class that pays a regular income is property/real estate. This is because both commercial and residential properties have to be occupied by tenants, who pay rent regularly. Once again, property investments can pay different levels of yield depending on the types of properties you invest in.

Alternatives

Lastly, there are some alternative investments that are also suitable for an income-focused portfolio, such as infrastructure, P2P lending and private equity.

Investing for income through funds

Some of the above asset classes can be accessed directly and with ease, whilst others can either only be accessed through funds or the hoops you have to jump through as an investor to get access may be a bit too many for most of us to want to even bother. This is where funds come in, to make your life a little bit easier. There are many funds (active and passive) in the market that invest in the above asset classes and they can be a great option for a retail investor who is looking for income.

Even if you aren’t looking for income-focused asset classes specifically but would still like to get some income paid out through the life of your investment, then the income share class might be an option for you. When investing in a fund you will typically have a choice between an income or an accumulation share class. If you choose the income share class any income generated by the holdings in the fund will be paid out to you at regular intervals. This is in contrast to the accumulation share class which is focused on capital growth and automatically reinvests any income generated back into the fund, thereby adding to your investment and the potential for future growth.

The pros and cons of income investing

Income investing has traditionally been considered an old person’s game since it can help create a comfortable retirement. However, this strategy could be suitable for investors of all ages depending on your goals and can also be used as part of a diversified investment strategy.

Pros

• It generates regular income which means you don’t have to wait until you sell an investment to make a return, which is typically the case with strategies focused on capital growth.
• It is considered to be a defensive investment strategy and can therefore act as a hedge in bear markets (you know, those times when everything and everyone are gloomy). This is because dividend-paying stocks are often large established companies with predictable growth, which tend to be less volatile.

Cons

• Total return for income stocks tends to lag growth stocks during times of economic expansion. Conversely, during times of economic difficulty, some companies may cut their dividends or stop paying them altogether to preserve cash. So, whilst dividend-paying stocks tend to be established companies with predictable growth, no company is bulletproof to recessions and economic turmoil, and thus the dividend itself (at least not the size of it) may not be as reliable.
• In some asset classes such as bonds, high-yield bonds have a higher yield for a reason. As discussed in our earlier post on asset classes, high-yield bonds tend to be issued by companies that may be less willing or able to pay those bonds back. In simple terms, this means that the bonds could default, which would leave the investor losing more than just their income.
• And finally, by going for an income share class of a fund, the miracle of compounding is somewhat diluted. Remember, every little helps! And those streams of reinvested interest could have a significant impact on your long-term returns.

You may already have a view on whether investing for income is for you. There are certainly lots of options out there, but ultimately it comes down to how important those regular payments are for you.

Date of publication: 7th August 2020