My finances, my projects, my life
June 6, 2023

Income – the investor’s friend

  Compiled by myLIFE team myINVEST August 19, 2022 50

Once you have decided to invest, you still need to decide what type of investment you are looking for. There are multiple approaches in investing and it’s never one size fits all. Making money with your investment will happen when your investment grows in value or pays you income. A carefully-chosen portfolio can deliver some return today and more in the future.

Growth investors want all earnings kept in the asset since this allows the investment to grow faster while income investors want profits returned as a form of income. If you are a young investor and you don’t need to use your capital in the short term, focusing on your capital growth is probably the best plan. But at some point, investors are likely to want more from their portfolio than just capital growth. For retirement, a child’s education, or just day-to-day living, generating an income may also be important. Many different types of asset generate income, and in some cases they are capable of offering both types of returns.

Generating an income from your investments isn’t as easy as it used to be. In the days before the 2007-09 global financial crisis, it was possible to obtain an income of between 3% and 4% from a cash savings account and as much as 5% from a government bond. Investors could readily generate an income exceeding inflation without taking much risk. Today, to generate a meaningful level of income – and outpace a renewed upsurge in prices – investors need to take more risk.

If you don’t want to wait to start making your money back, there are four main options to generate an income from your investments: dividends from shares; interest income from bonds; rental income from property; and alternative investments, which can include for instance infrastructure or music royalties. When examining the various options, it is also worth taking into account the potential for growth in income. With inflation at the beginning of 2022 reaching its highest level in more than 30 years, if your income fails to grow over time, it is liable to end up not being worth very much in the long run.

If your income fails to grow over time, it is liable to end up not being worth very much in the long run.

Income from the stock markets

For many investors, this will be the first port of call for income-yielding investments. The Eurostoxx 50 has an average dividend yield of around 2.5%, but it is possible to seek higher income through equity income strategies that specifically focus on higher-yielding stocks. However, keep in mind that nothing is guaranteed when it comes to investment. Past performance is not indicative of future results.

Dividends are paid out of a company’s profits – they are not like interest from a bank account. Companies can experience difficult periods, and during the pandemic businesses in different sectors of the economy were obliged to cut dividend payments. However, dividend levels have bounced back relatively quickly, and many companies have a long track record of paying dividend to shareholders. Dividends have also historically provided good protection against inflation.

The best way to minimise the impact of a particular company missing or reducing a dividend payment is to invest in a range of companies in different sectors and geographic regions. A global equity income fund will do this on behalf of its investors. In addition, holding shares in companies in diverse industries can ensure a portfolio also incorporates higher growth sectors such as technology, rather than relying solely on traditional fields such as petroleum and utilities.

Bond interest rates rebounding

The level of interest on bonds – debt securities issued by companies or governments, for which investors receive regular interest payments and repayment of capital when the bond matures – is based on the risk of the company that issued it becoming insolvent or a government being unable to pay its debts. The greater the likelihood of default, the higher the interest rate.

In the past, bonds tended to be the staple source of income in a portfolio, but over the past decade and a half interest rates fell to historically low levels, sharply reducing the income they generated. However, this is gradually starting to change as interest rates rise again, but bond yields remained very low in early 2022 by historical standards, particularly in Europe.

Because in most cases the income from a bond is fixed, they can put investors at a disadvantage at times of rising inflation.

High-yielding bonds do exist, but they tend to be those from riskier issuers such as companies active in emerging markets or those that already have high levels of debt. As with shares, diversification reduces investors’ risk and investment funds are usually a good option. Because in most cases the income from a bond is fixed, they can put investors at a disadvantage at times of rising inflation.

Riding the logistics boom

Property investment is usually in commercial buildings for industrial, logistics, office or retail use. A commercial property fund will pool your investment with those of other people, to invest in buildings that are rented out – investors’ income depends on the rental yield.

There will always be a risk that tenants find themselves unable to pay the rent, but under decent economic conditions a good commercial property building should be able to attract new ones.

Commercial property rents have usually offered some protection against inflation because landlords – including a fund’s manager – can increase rents at times when inflation is higher. However, this depends on the existence of sufficient demand, and areas such as high street retail property and offices have seen structural change in recent years.

The most successful real estate fund managers have steered their portfolios toward higher growth areas. These include warehousing and distribution centres, which are in greater demand because of the rise in e-commerce, as well as specialist industrial units.

Alternative income sources

In recent years investors have been turning to an increasingly broad and riskier range of alternative options for generating income, including infrastructure assets such as hospitals or toll roads. These often have inflation protection built in to their cash flows, so investors can expect their income to grow over time, whatever the behaviour of prices.

Driven in part by the trend toward sustainable investment, the range of options in green infrastructure now includes solar energy facilities, wind farms and battery storage. These are attractive to investors seeking assets that benefit the climate and environment, and some market analysts argue that they offer better long-term prospects than fossil fuel industries, in which investors risk being left holding stranded assets they are unable to exploit.

Other alternatives include music royalties, where investors can take a share in revenue from music rights of famous artists, and peer-to-peer lending through a portfolio of consumer or business loans. There are a range of specialist lending options, such as to healthcare companies or biotechnology groups.

Steady as it goes

Investors may be well advised not automatically to gravitate toward income options currently offering the highest yield. Unless the price of the asset is correspondingly higher, this may indicate that market participants expect the income level to decline in the future.

Focusing on steadily growing income is likely to be a better strategy. It is worth remembering that dividend figures only demonstrate what an asset or fund has paid out in the past, and offer no guarantees about what it will pay in future. Investors need to be comfortable that the source of income on which they intend to rely, whether company profits or rental income, is well placed to continue.

A resilient income portfolio is likely to incorporate shares, bonds, real estate and alternative assets, although the balance between them will depend on the economic and financial market climate, as well as the investor’s preferences in terms of risk, reward and liquidity. For many individuals, especially those in retirement, an income-focused portfolio that generates a steady, regular income can be more suitable than the potential of assets to yield capital growth in the future.

Many different types of asset generate income, including shares, bonds, real estate and alternative assets, and in many cases they are capable of offering capital growth as well.