Income Investing

June 2, 2015 / Investment Ideas

Income investing is simply purchasing assets (equities, bonds, funds, structured notes) which are paying a regular cash income to you just for owning them. This is the safest way to invest since you start receiving cash NOW, which can be reinvested into more income investments if you do not currently need the cash.

How do some assets pay cash?

With equities, you have a small ownership stake in company which means you also have a small claim to the profits being generated by the company. When a company is small the profits may be reinvested back into the growth of the company, but once a company has reached a sufficient size it may be generating more cash than it can use for further growth. This means it is better for the company to pay the cash profit to the owners of the company, which includes you. These payments are called dividends.

Bonds are debts which are owed to you. A company (or government) has borrowed money and makes interest payments to you on the borrowed amount are called coupons.

Funds which make cash payments from the equities, bonds, or other assets they own are called distributions.

Yield

The cash yield is the percentage of income being paid to you based on the purchase price of the asset. For example, if an equity is paying a $5 annual dividend and can be purchased for $100, then the equity has a 5% dividend yield.

If the share price increases to $120 and still pays a $5 annual dividend, the equity has a 4.17% dividend yield.

If the share price decreases to $80 and still pays a $5 annual dividend, the equity has a 6.25% dividend yield.

This means you can receive a higher yield by selecting assets to purchase when their prices are low.

Dividends vs Coupons

Income can be generated from both equities and bonds, so which is better?

In general, bond coupons will pay regular cash income which is more stable than equity dividends. Bonds are also safer because debt investors have a higher priority to receive cash than equity owners.

However, equity dividends will tend to increase over time which means the yield will increase. Equity investors will also benefit from any capital growth in the equity price increase.

Risk & Return

Income producing investments tend to be the safest types of investments, but they still need to be carefully selected and monitored. An investment with a higher yield can be an indicator for an income stream which has more uncertainty, which means it is a riskier investment. This is where Shoreline can assist clients in understanding their investments.

Both bonds and equity prices will fluctuate over time. It is possible for an investor to receive back less capital than they originally invested with both types of assets, but receiving a regular income stream NOW can help offset any possible capital loss in the future.

Diversification will reduce risk, so holding some coupon paying bonds and some dividend paying equities will recommended for an income investing strategy.