Income Investing Explained: Overview, Types, Benefits & Risks
Endowus Insights

Income Investing Explained: Overview, Types, Benefits & Risks

Updated
June 20, 2022
published
September 22, 2021
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income-investing-explained

Investing for income has always been attractive to Singaporean investors, making 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 heavily influenced by companies’ ability to pay dividends. The price surges of DBS, OCBC and UOB stocks following the recent lifting of dividend restrictions proves the point. But are the most popular forms of income investing always the best? Let's start at 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 a bond, 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. 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 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.

Want to know more about goal-based investing? Click here.

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 for holding on to our investments — we can afford to target a more growth-oriented, high risk portfolio.

While growth stocks, through capital appreciation, typically produce higher returns over the long run than income investments, the discrepancy in returns between the two may not be as great as we think, particularly with the extreme market volatility of recent years. This is especially true for investors who are in need of cash payouts from their investments to fund their living expenses.

Need help to determine your financial goals? Read this.

An investment portfolio typically has two sources of returns:

chart of investment income reinvested vs not reinvested
Source: Barclays Equity Gilt Study 2019. Investment period between end 1899 to end 2018.

Some investors may 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. For 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 this 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.

chart of yields and correlations of fixed income returns to equities

Risks of income investing

Interest-rate risk

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

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 higher credit quality companies as well. Recent fears regarding the Huarong and Evergrande debt crisis in China shows 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 checks 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 S$1 dividend per share out of its S$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 S$20 and pays S$1 dividend per share, its dividend yield is 5%.

Fixed Income Instruments and funds

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

Many people consider U.S. or Singapore government bonds to be virtually risk-free as they are backed by the full faith and credit of their governments and 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 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 which retail investors can buy through the ATMs of the three local banks for as little as S$500. While they have 10-year maturities, investors can redeem them anytime, with no penalties. However, each investor can only hold a maximum S$200,000 of such bonds.

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 considered safe investments that can be used for monthly income.

Money market funds 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 this 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 give higher returns.

Real estate investments

Many Singaporeans dream of owning multiple properties for creating 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 their rental properties..

Building your own income stream with Endowus funds

One of the key benefits of investing in unit trusts 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. 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 from our webinar and start investing now.

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