What is the Best Way to Invest for Income?

Demand for income remains strong thanks to an increasing number of retirees, record low interest rates, lengthening life expectancies and the dwindling use of annuities

Richard Whitehall 25 August, 2017 | 1:02PM

Five pound notes

Cashflow is king, with demand for income remaining strong thanks to an increasing number of retirees, record low interest rates, lengthening life expectancies and the dwindling use of annuities.

Yet, there remains significant conjecture about the best way to succeed in the pursuit of income, But before you decide the best way to invest for income, you must first consider what you are trying to achieve.

Income Investing and Sustainability

While the investment solutions available in the marketplace vary, we believe the sustainability of income and portfolio risk are essential considerations when building an income portfolio. For instance, while a retiree may be tempted by a high yield target, it may come with significant underlying risks. Further, if the investment capital is eaten into in order to sustain the target yield then the portfolio may not be able provide the investor with the income they desire in the future.

In the market, there is a range of peculiarities that are unique to the income investing objective.  One of the most prominent is the way the industry views dividend yields and dividend growth.

Dividend Yield vs Dividend Growth

To understand why income investors care so much about dividends, consider the long-term fundamentals of an investment and the structure by which it extracts income. To say this simply, a focus on high dividend yielding companies may actually reduce the ‘growth potential’ of total payouts. For example, a company with excessive dividend payouts could have higher leverage and less in reserve to reinvest or engage in buybacks.

The past 40 years have seen a rather dramatic change in dividend policy, including a growing preference for more flexible buyback programmes rather than traditional dividend payments.

This is an important point that is worth elaborating on. We know with hindsight that dividend yields have historically contributed 49.7% of the total return over the very long term – from 1871 to 2014 – and have comfortably been the most stable component of total returns.

This has supported income investing, as people desire to “live off the income” and let the capital look after itself. However, since 1970, dividend yields have fallen and only accounted for 27.6% of total returns. Driving this change has been the shift in corporate policy with ‘buybacks’ rising from just 5.4% of total returns over the long-term to 10.9% since 1970.

This is both an opportunity and a threat to income investors. With dividends making up a smaller portion of total returns, it may reinforce the need for robust income solutions.

This inevitably links back to the investment objective. By its very nature, it supports the notion that one should consider income more holistically, taking into account both the sustainability of the income as well as the means of delivering yield.

The issue of sustainability and risk is present in the bond environment too, where an income-focused mandate may increasingly tempt some to shift up the risk curve, potentially investing in lower-quality assets as a means of extracting additional yield.

During a cyclical upswing, such as the one we currently enjoy, this is easy to overlook. However, with the 10-year anniversary of the financial crisis upon us, we should be reminded of what can happen in a downturn and the impact this can have on the portfolios income investing appeals to.

Opportunities for Income Investors

On a relative basis, we continue to believe emerging market debt in local currency terms offers appeal, however even for this asset class, the sustainability of its recent rally must be carefully considered.

Of course, the natural extension is to contemplate how to deal with an income objective during periods when valuations are stretched. As counterintuitive as it may seem, the best solution for some cautious income investors could be to hold more cash to protect their portfolio. By doing so, they may need to be accepting of lower income now, but this could protect their ability to generate higher levels if income in the medium term.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Richard Whitehall

Richard Whitehall  is a portfolio manager for Morningstar Investment Management