Income investing explained: overview, types, benefits & risks

Investing for income has always been attractive to Singaporean investors, making the Singapore Exchange (SGX) an attractive listing location for many real estate investment trusts (Reits) and business trusts to cater to such high demand.

Share prices are also often heavily influenced by companies’ ability to pay dividends. This was seen from the stock price surges of the Big Three local banks — DBS, OCBC, and UOB — after dividend caps were lifted in July 2021.

But are the most popular forms of income investing always the best? Let's start from the beginning.

What is income investing?

Income investing refers to investing in assets that can provide a constant stream of income. Such investments can be stocks that pay regular dividends — dubbed “income stocks” — or fixed-income instruments, such as government and corporate bonds.

With bonds, investors receive a fixed interest in the form of coupon payments, until the bond’s maturity date. Upon maturity, investors get back their principal amount. Learn more about bonds and bond funds here.

Other income investments include certificates of deposits and money market funds.

Who is income investing suitable for?

Income investing is particularly suitable for investors who have longer-term financial goals such as saving for retirement or for their children's education.

As income investments are generally subject to fewer short-term price swings, investors can be assured of more stable and predictable returns to fund their multi-year retirement or financial commitments.

Income investing vs growth investing

That being said, there is a common misconception that income investing is only for retirees, those close to retirement, or investors with a lower risk appetite.

For the longest time, most of us have been conditioned to think that when we’re younger and have a longer investment horizon — which is the length of time we have to hold on to our investments — we should only target a more growth-oriented and high-risk portfolio.

Indeed, growth stocks typically produce higher returns, through capital appreciation, over the long run as compared to income investments. But the discrepancy in returns may not actually be as large as we think, particularly with the extreme market volatility of recent years.

There are also investors who might need or prefer to receive cash payouts from their investments to fund their living expenses.

Read more: Here's how you can prioritise your financial goals

An investment portfolio typically has two sources of returns:

• Capital appreciation from any price increases in your holdings
• Regular income from stock dividends or bond coupon payments

Several studies of long-term data show that income investments can have a substantial impact on investors' total investment returns. For instance, over the last century, about 75% of the returns from UK equities came purely from dividend yields, according to the 2019 Barclays Equity Gilt Study. And in the US market, Fidelity estimates that almost half of the total returns from the past 30 years have come from dividend income.

Some investors prefer to construct their portfolio to focus on capital appreciation or “growth”, while others may prefer to focus on regular payouts or “income”.

Benefits of income investing

Regular income

Income investing assures you of a steady stream of income. In fixed income investing, companies or governments that issue bonds are legally bound to pay you bond interest or coupons. They must also repay your principal amounts when your bonds mature, unless they default or are under liquidation. This obligation means you can expect to receive the income even in bear markets.

Dividend stocks also give you regular income. Dividends may come from a company’s yearly operating profits, which it shares with its shareholders. Note, however, that not all companies pay dividends, so not all stocks are dividend stocks. Also, companies are not obliged to declare dividends every year. They may cut or stop their payouts in a particular year if the economy or their business is not doing well.

Recall that Singapore banks capped their dividends in 2020 at the height of the Covid-19 pandemic, under restrictions from the Monetary Authority of Singapore.

In general, firms that are known for paying dividends have a history of making regular dividend payments. They tend to be more established businesses in more mature industries. These include banks, telecommunications, utilities, tobacco, food staples, essential goods and Reits.

Potentially lower volatility and risk

Income investments can help you create a more defensive and diversified portfolio that is better able to withstand market gyrations. 

During bear markets, capital gains almost always disappear for stocks. However, income assets such as bonds, especially US Treasury bonds, are lowly or negatively correlated with stocks. This means that their prices don’t move in sync. If stock prices move in one direction, bond prices either move very little or may even move in the opposite direction.

Balancing the two helps you minimise losses and manage risks during market downturns.

Risks of income investing

Interest-rate risk

Income investments may not be affected much by market declines, but they are certainly affected by interest rates. When a country’s interest rates rise, income investments tend to lose their value.

On one hand, high interest rates affect the ability of dividend stocks to share profits with shareholders. On the other, bond prices and interest rates move inversely to each other. This means that bond prices fall as interest rates rise. This is because as interest rates rise, investors will sell off their existing bonds in favour of new bonds that will be issued with higher coupon rates.

Inflation risk

Inflation is one of the primary risks for income investors. Although you are promised a fixed stream of payments through fixed income investing, these payments also likely remain at a fixed dollar amount, even if inflation rises.

Additionally, inflation diminishes the real value of your bonds' principal too. Both factors create the risk of losing value on your investment, even as you collect payments and receive your principal back at maturity.

One way to deal with inflation risk is to invest in bond funds that have a mandate to invest in bonds or bond funds that are inflation-linked, such as the PIMCO Global Real Return Fund.

Default risk

The issuer of a corporate bond may default on its debt obligations, when it cannot make further income and/or principal payments. In addition, bonds carry the risk of being downgraded by credit-rating agencies. This may affect their prices.

This can affect companies of a higher credit quality as well. Recent concern regarding the Huarong and Evergrande debt crisis in China show that even companies that used to be investment grade can face default risk, which makes diversification very important.

What are the best investment options for regular income?

With proper planning, investors can use a mix of products to create their own streams of monthly income. The best way to approach this is to prepare a portfolio that is diversified across asset classes, countries and sectors. Below are some building blocks for this:

Dividend-paying stocks and funds

Buying dividend stocks, or funds which are invested in stocks with a track record of paying regular dividends with good yields, is a common part of an income portfolio. Typically, larger, well-established companies are preferred for this. If you choose your stocks well, you can enjoy the best of both worlds: regular dividend cheques and capital gains if their stock prices rise.

For dividend-paying stocks and funds, these are the key terms you need to take note of:

Payout ratio

A company’s dividend payout ratio is the proportion of the earnings it pays out as dividends to its shareholders. This is typically expressed as a percentage. Whatever amount that is not paid out is retained by the company to pay off its debt or reinvest in its core operations.

Suppose that ABC decides to pay $1 dividend per share out of its $10 earnings in one year. Its payout ratio is 10%.

Dividend yield

The dividend yield of a stock is the amount of dividends a shareholder receives divided by the stock’s current price. Again, this is expressed as a percentage.

In the above example, if ABC is trading at $20 and pays $1 dividend per share, its dividend yield is 5%.

For a simple glossary of common investing terms, click here.

Fixed-income instruments and funds

Government bonds from developed countries are considered safe investments as they are guaranteed by the government.

Many people consider US or Singapore government bonds to be virtually risk-free as they are backed by the full faith and credit of their governments and investors will get back the face value of their investments as long as the bonds are held to maturity. The US and Singapore governments have so far never defaulted on their obligations.

The Singapore Government Securities (SGS) bonds that are available on SGX have poor liquidity. To give retail investors access to bond markets, the government in 2015 rolled out a 10-year Singapore Savings Bond (SSB) which retail investors can buy easily for as little as S$500. While they have 10-year maturities, investors can redeem SSBs anytime, with no penalties. However, each investor can only hold a maximum S$200,000 of such bonds.

Read more: How should investors look at Singapore Savings Bonds after the record Aug 2022 tranche?

A better alternative may be professionally-managed mutual funds that invest in income-producing assets that give you immediate access to a diversified range of fixed income products. Some of these can be local currency hedged, so that you do not take any foreign exchange risk with them.

Money markets funds

Money market funds are also considered safe investments that can be used for monthly income.

They are short-term debt instruments issued by a government, banks or big companies. They have short-term maturities of as little as a few days up to a year. Because of their short durations, they are typically considered risk-free, especially if they are from high-quality issuers.

The key disadvantage is that money market funds have a low yield in a low interest rate environment. A way to circumvent this is to include short-duration bond funds, such as those found in Endowus Cash Smart, to achieve higher returns.

Real estate investments

Many Singaporeans dream of owning multiple properties to enjoy monthly rental income streams. This, however, requires big upfront cash investments.

Other costs not often factored in by property investors include maintenance, income tax on property income, interest, and service and conservancy charges for the rental properties.

Building your own income stream with Endowus funds

One of the key benefits of investing in unit trusts, also known as mutual funds in the US, is the liquidity of the investments. You are free to sell off a portion of the investments and get the proceeds from the sale quickly.

With unit trusts, you canrely on Endowus Income Portfolios as a way to get a managed solution.

Otherwise, you can also pick and choose from our curated list of funds and refer to the above list of funds as an example. These funds are chosen for their robust levels of payouts and that are backed by unique investment strategies. With our 100% cashback on trailer fees and allowing access to institutional share class funds, you will get the most cost efficient solution on Endowus.

In contrast, real estate investments might have to be sold in much larger denominations. You can consider the range of income funds available on Endowus to build your income portfolio. Find out more about these funds here.

To get started with Endowus, click here.

Next on the Endowus Fin.Lit Academy

Read the next article in the curriculum: The power of compounding interest explained

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