Income Investing Strategy: Looking for Safety With Regular Payouts
Table of Contents
Income Investors search for investments that are safe and stable and that will provide a steady stream of current income. This doesn't mean that if their portfolio grows 10% this year that they will take that money out of their account and use it as income. In fact, Income Investors try very hard to avoid touching their principal. Capital preservation is key to this strategy because they are using their investments to generate income. The two most common forms of income that these investors seek are Dividends from Stocks and Coupon Payments from Bonds.
This is a research-intensive strategy because it requires a lot of Stock AND Bond related fundamental analysis. Since Stocks and Bonds are so different, you will need to learn two different variations of fundamental analysis. Why are Stocks and Bonds so different? When you buy a stock you are buying a small piece of that company's assets and earnings, you purchase "equity". When you buy a bond, you are lending a company or government money to cover debt or for expansion projects, you purchase "debt". Income Investors need to understand enough about the structure and risks of both asset types to make investment decisions with confidence.
Like Value Investing, Income Investing is a buy-and-hold strategy, they don't concern themselves with short-term market trends. However, that's where the similarity ends, Income Investors aren't looking for undervalued companies, they are looking for safe incoming producing assets, there is much less emphasis on capital growth.
Investment Selection Methods
To help you better understand the differences between Stocks and Bonds we'll break this section into two parts, Stock Selection Methods and Bond Selection Methods.
Stock Selection Methods
Since most stocks don't pay dividends and those that do can change their policy tomorrow, choosing stocks is the more time consuming piece of analysis for Income Investors. Their research is designed to identify well-established Large Caps, often Blue Chips, that have a long track record of slow and steady price appreciation, stable long-term sources of revenue and generous dividend payouts.
Because Income Investors already have a clearly defined population of stocks to choose from, large caps with generous dividends, their initial screening analysis simply eliminates stocks that don't align with their strategy. They try to eliminate companies that exhibit excessive volatility, are part of turbulent industries, have new unproven products, experience excessive revenue and expense fluctuations, or are in declining periods of their growth cycle.
Stocks that pass these minimum requirements can then be scrutinized more closely and ranked. The final Income Investing analysis is designed to identify which of these remaining companies are best suited to protect capital, provide modest growth and generous dividends for long periods of time.
Some of the common stock-related terms you will hear frequently from Income Investors are Dividend Yield, dividend reinvestment, and capital preservation. The Dividend Yield measures a stock's return as a percentage of the share price, and the higher the better. Income Investors typically look for yields greater than 5%, but it's important that their selection criteria takes into account the increased risk that goes hand-in-hand with a higher yield. Dividend reinvestment simply means using the share of earnings that the company passed to you in the dividend to buy more of their stock. If an Income Investor doesn't need the dividend income, this is a great way to boost returns. Capital preservation doesn't really need a definition, Warren Buffet summed it up best with his mantra "don't lose money", which cuts right to the heart of this strategy. If an investor uses these terms frequently in a conversation, you are very likely talking to an income investor.
Bond Selection Methods
Since many of our readers aren't familiar with bonds we wanted to provide a one-paragraph introduction before we talk about selection methods. A Bond is simply an innovative way for a company or even for governments to borrow money at reasonable interest rates. The reason a Bond system is needed is because there isn't a bank in the world that could or would lend the vast sums needed by the US Government to cover US debt or needed by some of the world's largest companies to fund expansion. When you buy a bond, you are one of many creditors who have provided a loan. In return, the issuer will distribute fixed interest income payments twice per year called Bond Coupon Payments. These payments won't change regardless of the Bond's price fluctuation. When the bond reaches maturity (ends), you will receive your price adjusted principle back.
All Income Investors consider a Bond's credit rating before they buy. These credit ratings are very important because there is always the chance that a government or company will fail to pay back the loan. The credit rating estimates the chance that a bond will default on its debt. There are three major Bond rating agencies, Moody's, Standard & Poor's, and Fitch's Rating Services. They break their ratings into A, B & C, "A" being the safest Investment Grade Bonds, and all "B" & "C" considered Junk Bonds. Better credit ratings mean a safer Bond but also means a lower yield so Income Investors have to find a rating that makes them comfortable with both the risk and the return.
Income Investors also spend a lot of time studying interest rates because they have a major impact on a bond's price. When interest rates rise, bond prices drop and when interest rates drop, bond prices rise. How does this affect a Bond? A Change in a Bond's price changes the yield, which is a measure of a bond's profitability.
For example, if you have a $5,000 bond with a 10% yield you know that it will pay $500 worth of coupon payments. If interest rates rise and the price drops to $4,000 the yield goes up to 12.5% ($500/$4,000).
Income Investors that are about to buy a bond want interest rates to rise because this drops the price and increases the yield, which means greater profitability. However, if they already own a bond they want the opposite. Income Investors that already hold a bond want interest rates to drop because this will increase the price, and since their rate is already locked, they benefit when they sell the bond for a profit in the future. As an Income Investor, you will spend a lot of time trying to estimate the impact of changing yields and bond prices and predict future interest rate changes.
Well-balanced and fully allocated portfolios will contain some percentage of bonds, they are not unique to Income Investors, so you will hear bond terminology a lot. The only time bond talk will give you any indication that someone is an Income Investor is if they have a significant percentage of their portfolio in bonds, especially if they also hold a lot of high dividend yield stocks.
This strategy requires that you master Stock and Bond fundamental analysis and they are quite different so the initial learning curve is steep. Many people pick up some Stock fundamental analysis from implementing other strategies or from their favorite investing websites and newspapers. Bonds, on the other hand, are not as popular an investment vehicle for the average investor so most people don't know a lot about them, especially not beginners. Give yourself ample time to study before you start buying if you choose this strategy.
You will never get the returns of the market with this strategy and that is intentional, it is not a result of a flaw in the strategy. Income Investors want to preserve their capital and generate income, they are not trying to keep up with the market because they don't want to take on the market's risk. Income Investors play a delicate balancing act. They have to accept enough risk to grow more than the current inflation rate or they aren't meeting the most fundamental objective of this strategy, capital preservation.
There is a lot of interest rate risk involved in this stock market investing strategy since they have such a major impact on bond prices and yields. If you wind up buying bonds when interest rates are dropping and selling them when rates are rising, you kill the yield. This eliminates a lot of the income that the strategy is supposed to create. Finally, while this is a very tax efficient strategy overall, a chunk of your income, the dividends, will be taxed at 15% unless your money is in a tax deferred account.
This is a very conservative strategy, Income Investors don't have to worry about their portfolios dropping 3% in a single day which does occasionally happen to the stock market. They buy bonds and very mature stocks with a long history of steady growth and generous dividends. Even if they take short-term losses due to market volatility, they know that the type of stock in their portfolio will eventually recover.
The two different assets that make up an Income Investors portfolio, stocks and bonds, can offset each other. Remember that we said rising interest rates hurt bonds by decreasing the bond price? While rising interest rates hurt stocks as well, they usually occur when stocks are doing great. The Fed increases rates to control inflation and contain "irrational exuberance". The reverse is true as well. Bonds thrive in an environment where rates are dropping and this usually occurs when stocks are doing poorly, the fed is trying to jump-start a slowing economy with rate cuts.
Finally, bonds offer a couple of unique advantages. When you buy bonds, you are almost certain to receive your principal and at least some profit back. There are very few defaults, especially among investment grade bonds. Bonds also offer investors an opportunity to buy Tax-Free investments. Municipal Bonds, for example, will not be taxed regardless of whether or not they are traded in a tax-deferred account.
Income Investing is huge and growing in popularity, many baby-boomers are switching from more aggressive strategies to Income Investing in the final years of their career to protect their savings. Before you jump on the bandwagon, make sure this strategy fits your current situation.
Income Investing will never be a market beater and therefore won't be popular among investors with 10+ years to retirement. Why not? Because they tend to be more aggressive investors who don't want to sacrifice capital growth for security when they know they have plenty of time to recover from any market corrections or recessions.
Income Investors will always lag behind more aggressive strategies, but for them, this is an acceptable trade-off for the reduced risk and volatility. Keep in mind that Income Investing is not intended to beat the market, it is designed to provide current income and protect your nest egg, and in these two areas, it excels.
You've probably already figured out that this is a very popular strategy among retirees. Income Investing also appeals to very conservative and bearish investors that prefer security and income over the capital growth associated with more aggressive strategies.
If you are a Value Investor switching over to Income Investing, the transition will be easy. Value Investors have a solid background in fundamental analysis and will only need to add some bond knowledge to their arsenal. Those switching from other strategies face a steep learning curve. It's manageable if you have a knack for and enjoy analysis, but be prepared to study a lot. Because you need to master fundamental analysis for two asset types as different as stocks and bonds, this can be a challenging strategy for beginners.
This is a buy-and-hold strategy, you won't be trading a lot because that would create tax liability and defeat the purpose of the strategy. Like Value Investing, if you are great at fundamental analysis this can actually be a low maintenance strategy. You work hard to select stocks and bonds and then you just sit back and collect income.