The Basics of Income Investing

What is income investing and what routes to income are available to investors? We explore the merits of equities and bonds when building an income portfolio

Holly Cook 5 October, 2015 | 11:49AM
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This article is part of Morningstar’s Guide to Income Investing. Whether you are looking grow your pension pot, or invest for retirement income, this week we have all the news, information and education you need.

With interest rates at historic lows for several years now, investors have to look further for the income that in the past had been ensured by savings accounts and gilts. Income investing is the process of selecting investments designed to deliver a steady stream of income over a certain period of time.

This goal can be achieved in a number of ways, including owning corporate or sovereign debt, equities that pay dividends, or funds that provide access to both. In contrast with selecting investments for their purported capital gain—the profit that can be made by selling the investment at a higher price in the future—income investments should pay the investor an income almost irrespective of the investment’s market value.

Bonds: Seeking Yield in Fixed Income

Bonds are often considered central to income investors because of their nature of delivering fixed rations of income over set intervals. Seeking income in developed-world sovereign debt markets has traditionally been the way to shelter one’s savings from risk, but recent developments have forced investors to look further afield as these ‘no risk’ investments currently offer a negative real return (the coupon rate that they pay out is less than inflation).

Even within the fixed income space there are varying degrees of risk, however. High-yield bonds, for example, are securities that pay a fixed interest but are below investment grade bonds—their risk of default is relatively high and therefore their providers pay out higher yields to the bond holders who are willing to accept the relatively higher risk involved. A metric often sited alongside high yield bonds is the spread between these securities and higher-quality, lower-risk fixed income, such as UK gilts or US Treasuries.

Stocks: Seeking High Dividend Companies

Looking for income on equity markets boils down to considering attractive dividend opportunities. There are several considerations to keep in mind. One of the ways that companies redistribute profits to shareholders is in the form of dividend payments. It is often companies that are no longer in expansion mode that are considered to be the most reliable dividend-payers, given that they opt to reward shareholders rather than reinvest profits for growth. Having said that, there are plenty of expanding companies that also offer dividends.

It is important to recognise that a company’s dividend policy can be an indication of a number of corporate strengths and weaknesses. For example, there’s no guarantee that a company will be able to achieve its projected dividend growth, as was seen in 2010 when BP was forced to cancel its dividend following the Macondo well explosion. In addition, a company that redistributes high dividends will have less capital to reinvest and contribute to its own growth, which in turn could inhibit its ability to maintain high dividends. Thus, an historical record of paying attractive dividends is a helpful indicator to consider when seeking yield. Also note that a heavily-indebted company may struggle more than less leveraged peers in maintaining a steady dividend stream in tough market conditions.

A number of industries have historically held appeal for yield seekers, utility providers and real estate investment trusts being two examples.

Risks: Inflation and Interest Rates

Current low interest rates and the risk posed by above-target inflation are among the risks to income. These factors can erode the appeal of securities that pay fixed interest or dividends.

In terms of fixed income, the longer a bond’s duration, the more exposed it is to the risk of rising interest rates. Fixed income funds can offer a degree of duration diversification and a hedge against the effect of interest rate hikes, but it is important to acknowledge that the more diverse the duration mix, the harder it is to measure the impact of monetary policy changes. The mechanics of duration are complicated, and not every fund is sensitive to rising gilt yields, but one useful rule of thumb is that for every 1-percentage-point increase in market yields, you might expect a fund to lose an amount roughly equal to its duration.

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.

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About Author

Holly Cook

Holly Cook  is Manager, Morningstar EMEA Websites