When you stop earning income from working it can be difficult to switch to spending capital to supplement the income from the investments.
To prevent drawing down on capital, many take on higher risk on their portfolio to earn higher income. But not all income investment opportunities are equal in terms of risk and return.
Almost every day you read an advertisement offering a high yield investment. It is very attractive and difficult to not get excited, but it is very important to read the fine print and to understand the risk to your capital before investing.
The key to a successful income-focused investment approach lies in matching your income needs to various sources of investment income. By spreading investments across different asset classes, investors can potentially enhance yield while mitigating risks. In this article, we will explore different sources of investment income and explain how a diversified income approach can provide reasonable yields. Additionally, we will discuss potential pitfalls and what can go wrong when investing for yield.
If you prefer videos, please watch our video on different income investment opportunities and strategies here.
Types of Income producing investments
1. Government Bonds
Short term Government bonds are the safest form of income you can buy. Longer term government bonds have security from the government, however their price (your capital value) can fluctuate quite wildly depending on interest rate moves. It is important to remember that bond prices generally move in the opposite direction to interest rates.
Counter to this is the protection that long-term government bonds can provide during periods of crisis. Typically, the price of a long-term government bond rises during risk off periods (declining share prices) which can provide needed support for your investment portfolio.
All income portfolios benefit from having a government bond component as a protection against crisis periods.
2. Bank accounts including Term Deposits
Almost everyone has a bank account and until recently, you were not being paid to store money in a bank account. The term “cash is trash” was used widely during the low interest rate period of the last decade. Today, deposit rates have risen, and some term deposit rates have some decent yields.
The Australian government backs $250,000 per institution for your deposits. Those with significantly more should diversify their cash. The bank failures in the US durind early 2023 have highlighted that banks are leveraged institutions and you should be wary of over exposure to a single bank.
The most frustrating issue with deposit rates is that the banks frequently increase or decrease their rate and to achieve reasonable rates you need to keep moving banks. Setting up multiple bank accounts is a pain. We have found that a platform for managing this such as Australian Money Markets to be an effective tool for moving money between deposits without needing to establish multiple accounts.
3. Corporate Bonds
There is a very wide range of safety for corporate bonds. There are AAA rated senior secured bonds which have as much chance of losing your money as nuclear war and there are non-investment grade unsecured junior subordinated junk bonds. The gap between these types of investments is extremely large.
Generally speaking, a solid portfolio of diversified corporate bonds should yield more than government bonds. The risk lies in the movement of the bond prices during a crisis. As previously stated, government bonds values rise during in a crisis, corporate bond values often fall in a crisis as credit spreads widen. For this reason, if you are relying solely on an income portfolio, corporate bonds should be measured against your government bond portfolio to manage risk.
4. High Yield Bonds, Hybrids & Floating rate notes
High yield bonds are simply corporate bonds that have higher yields and are generally perceived to be riskier. These bonds can provide higher returns over time, however they come with significantly more volatility risk than other bonds.
A retiree should not overly expose themselves to high yield bonds.
As previously stated, if you see an advertisement for something that looks too good to be true, it almost certainly is likely to be problematic. “Safe” or “secure” 12% or 15% income returns do not exist in a world where the 10 year government bond is paying 4%. A good rule of thumb is that if it is paying more than 1-2% above the government bond yield, understanding the risks inherent is critical.
Hybrids are bonds that convert to shares at maturity if the borrower can not repay in cash. They are higher risk than corporate bonds and therefore pay higher returns. There are many hybrids on the Australian stock exchange.
Floating rate notes are bonds that have a floating rate vs a fixed rate of a bond. They are linked to a short term cash rate like the RBA cash rate or LIBOR. They generally pay lower interest than the fixed rate bonds however since they are floating, they can coupons can increase as the rates increase without effecting the capital value unlike bonds. These offer greater capital stability vs a bond.
5. Annuities:
Annuities provide a regular income. They are usually offered by an insurance company who invests the money and promises to pay a set amount at regular intervals. They can be for different terms. Some include drawing down on capital and others include just interest income. They can be linked to inflation, interest rates or the market. Some offer age pension benefits. There are large differences in annuities and whilst they can provide certainity of returns it is important to understand the impact on your estate and the product provider investment strategies and risk levels.
6: Dividend-Paying Stocks:
Dividend-paying stocks are shares of companies that distribute a portion of their profits to shareholders. These stocks provide regular dividend payments, often quarterly, which can contribute to an investor's income stream. Dividend stocks can offer both income and potential capital appreciation.
In Australian, the attraction of dividend paying stocks is the franking credits, whereby you can earn increased yield from the tax credits paid by the company.
Where we see many go wrong is to invest solely for yield and not think about the safety of the company. Formerly labelled “Blue Chips” such as Telstra and AMP have been terrible investments even including their dividends. Or many investors are buying mining companies due to their temporarily high yield, without thinking about the steel consumption of China reducing over time.
It is essential to research and select companies with a history of consistent dividends, financial stability, and growth prospects.
7. Real Estate Investment Trusts (REITs):
REITs are investment vehicles that own and manage income-generating properties, such as office buildings, shopping centers, and residential complexes. By investing in REITs, individuals can gain exposure to real estate without directly owning physical properties. REITs generate income from rent and can distribute a significant portion of their earnings as dividends. They provide an opportunity to diversify income sources beyond traditional stocks and bonds, but investors should be aware of the risks associated with the real estate market and REIT-specific factors.
8. Peer-to-Peer Lending:
Peer-to-peer (P2P) lending platforms connect borrowers directly with individual lenders. As an investor, you can earn interest income by lending money to borrowers through these platforms. P2P lending offers potentially higher yields compared to traditional fixed-income securities, but it also carries credit risk and borrower default risk. Due diligence and proper diversification are crucial when investing in this alternative income source.
The Power of Diversification:
A diversified income approach involves allocating investments across multiple income-generating assets to reduce exposure to individual risks. By diversifying, investors can potentially enhance their overall yield while spreading risk. A well-diversified income portfolio may combine bonds, dividend-paying stocks, REITs, and other income-generating assets, each contributing to a balanced income stream. Diversification helps protect against the negative impact of a single investment's poor performance and promotes stability in the face of market volatility.
Risks and Pitfalls:
Investing for yield comes with certain risks and pitfalls that investors should be aware of:
1. Market Volatility: Income-generating assets can be influenced by market fluctuations, impacting their yields. Economic downturns or unexpected events can disrupt cash flows, potentially affecting an investor's income stream.
2. Credit Risk: Certain income investments, such as bonds or P2P lending, carry credit risk. If an issuer or borrower defaults on payments, it can significantly impact the investor's income.
3. Interest Rate Risk: Fixed-income investments are sensitive to changes in interest rates. Rising rates can reduce the market value of existing bonds and potentially affect their yields.
4. Dividend Reductions: Companies may reduce or suspend dividends due to financial difficulties or strategic decisions. This can affect the income generated from dividend stocks.
4. Product Provider Risk: Some investments are via a company such as an insurance company. Should that company go bust, then your investments may be at risk.
What can you do?
A diversified income approach provides investors with a reasonable yield and helps mitigate risks associated with investing for income. By combining various income-generating assets like term deposits, bonds, annuties, dividend-paying stocks, REITs, and alternative investment options, individuals can build a portfolio that balances income, growth potential, and risk. However, it is crucial to conduct thorough research, monitor investments, and remain mindful of the potential risks and pitfalls mentioned. By maintaining a disciplined and diversified approach, investors can aim for stable income generation and long-term financial success.
If you would like to discover opportunities to increase your investment income, watch our video where we discuss some of the income investments in our portfolios.