Income Investing Strategy Builds Financial Security
People who follow a long-term strategy of investing for income will find that it brings both financial security and peace of mind.
Picture the following real-life situation:
A company executive approaches you with a fantastic offer. Be one of the first four people to join a new division that will ensure the future of the company.
Get a big title, more income, extra perks and the opportunity to grow your career. You will be able to send your three teenage children to decent colleges without going deeply into debt.
The new division has a great start. It grows to more than 450 people. But signs of trouble start to show as a result of a slowing economy.
One day, the executive announces a layoff. He announces another layoff, and another, and another. Hundreds of people lose their jobs. Will you be among the next to go?
Job security plunges to zero. Will a layoff mean no college? Will you lose your home or cars because of unpaid debts? How will you pay for health insurance?
An income investment strategy may not help job security, but it will help financial security.
It relies on six basic ideas:
- Visualize the number: $500,000
- Chase stable yield, not high yield
- Diversify asset classes
- Find value: buy low, sell high
- Master taxable versus nontaxable
- Reinvest all dividends
- Income + value = growth
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Visualize the Number: $500,000
Setting a goal of $500,000 yielding 6% or $30,000 a year seems impossible for many people. But it’s not. It just takes time.
The average American family is making about $53,000 a year, according to the most recent numbers available from the U.S. Census Bureau.
If that family saved 20% of their gross income in nontaxable accounts such as IRAs at a return of 6% a year, they would reach $500,000 in about 20 years.
Twenty years may feel like a long time for young people. But those 20 years will fly by. People in their 40s with children have reached the peak of their financial pressures because of a mortgage for a larger house and college expenses.
Anyone who faces a job loss will find that $30,000 a year of investment income plus a $500,000 portfolio as a backup provides a strong sense of financial security.
Although inflation will eat some of the buying power of that income, it will still be enough to pay for many basic necessities such as a home mortgage and other expenses.
Lesson: Even if a 20% savings rate is not desirable -- even though it is possible -- a disciplined middle class couple can reach hundreds of thousands of dollars of income-producing investments.
Chase Stable Yield, Not High Yield
The chart above shows the 10-year history for the IShares IBoxx High Yield Corporate Bond ETF (ticker symbol HYG). It is the largest high-yield, exchange-traded bond fund (ETF) on the U.S. stock market today.
HYG and others like it are popular funds to invest for monthly income. As its name implies, HYG provides investors with a dividend yield via corporate bonds that have a risk rating of B or below. That risk rating means they are more liable to default than high-grade corporate bonds.
It provides an attractive yield of about 6 percent at the time of this writing. But the chart shows that it does not give an attractive return on investment over time.
The price has declined 23 percent over the last 10 years with the steepest decline taking place during the Great Recession and another one developing at this time.
Lesson: Look at long-term charts for any investment to see if they have steady growth or decline over time.
Being diversified is one of the most important parts of an income investment strategy to maximize results and minimize risk.
Diversification starts with the three major asset classes --stocks, bonds and cash. Each is capable of producing income at some point depending on many factors including interest rates.
How much to invest in each class depends on the individual investor’s age and other factors. A well-known guideline recommends subtracting your age from 100 to determine how much to invest in stocks. Put the rest in bonds and cash.
Stock Income Strategy
For income investors, stocks offer five opportunities:
- Dividend growth stocks
- Utility stocks
- Real estate investment trusts (REITs)
- Preferred stocks
- Master limited partnerships (MLPs)
Dividend growth ETFs are a good starting point for investing in stocks of companies that have a history of increasing their dividends every year. These dividend increases often exceed the rate of inflation.
Five major dividend growth ETFs, their ticker symbols and annual yields are:
- IShares Select Dividend (DVY, 3.4%)
- iShares Core Dividend Growth ETF (DGRO, 2.6%)
- SPDR S&P Dividend ETF (SDY. 2.5% yield)
- Vanguard Dividend Appreciation ETF (VIG, 2.4%)
- PowerShares Dividend Achievers ETF (PFM, 2.4%)
Investors can find more diversity in utility stocks. The largest ETF is Utilities Select Sector SPDR ETF (XLU) with the same current yield as DVY at 3.4%.
Income from Real Estate, MLPs and Preferred Stocks
Real estate investment trusts (REITs) can provide yields higher than than dividend growth ETFs. The largest ETF in the group is IShares U.S. Real Estate (IYR) with a current yield of 4.1%.
Preferred stocks are hybrid investments that have features of both stocks and bonds. The largest preferred stock ETF is iShares US Preferred Stock (PFF) with a current yield near 6%.
Preferred stocks may have features of both stocks and bonds, but they behave more like bonds. They are less risky than junk bonds and more risky that investment-grade corporate bonds.
Finally, Master Limited Partnerships fall into a special class because of their tax advantages. These partnerships usually hold oil and gas assets, which have seen steep declines in value over the past year.
One of the largest of these MLPs is the Alerian MLP ETF (AMLP) with a current yield of 11.8%. It also has declined 39% in price over the last year.
MLPs often treat dividends as nontaxable return on capital. But this appealing advantage has complex IRS rules. Research the topic thoroughly or consult with a tax or financial advisor before investing.
Income Investing Video
Bond Income Strategy
The yields on bond funds depend on interest rates and other factors. It is possible to diversify among different types of bond funds:
- Convertible: tends to mimic the stock market
- Emerging market: high risk with higher yields
- Floating rate: yields fluctuate with interest rates
- Government: lowest risk and lowest yield
- High yield: highest risk and, as the name suggest, high yield
- Inflation: goes up if consumer prices increase
- International: corporate and government bonds outside of the U.S. for diversity
- Investment-grade corporates: moderate risk and moderate yields
- Mortgage: horrible risk during the Great Recession, moderate risk now
- Tax-free municipal bonds: best for taxable accounts
Anyone who is new to an income investing strategy might start with an exchange-traded fund such as AGG that invests in a mix of corporate, government and mortgage-backed bonds. It has both a low yield with low risk. It is the largest bond ETF in the world, followed closely by BND, which has a similar approach.
The next largest is LQD, which holds investment-grade corporate bonds. It is a small step up in risk and yield.
Diversifying into more targeted bond income categories requires an understanding of and regular attention to interest rates. Rising rates often decrease the price of bond funds. A new bond with a 5% yield will produce $50 a year on a $1,000 investment. But an existing bond with a 4% yield will fall in price because it produces less income.
Find Value: Buy Low, Sell High
The HYG high-yield bond chart at the beginning of the article illustrates why an income investor should buyi low and sell high and not the other way around.
Yahoo Finance, Google Finance, CNBC and many other online sources provide long-term charts for every major stock, bond, ETF and other investments.
Always look at the five- or 10-year chart before making any investment to see if the current price is high, low or average over the long term.
Even better, use the comparison feature that many sites offer that provide a look at two or more investments over the same period.
They make it possible to see how an investment-grade corporate ETF like IShares IBoxx Investment Grade Corporate Bond ETF (LQD) is doing versus a more conservative bond fund such as the more conservative Core Total U.S. Bond ETF (AGG), which is the largest bond ETF of all.
It is better to buy a fund with a low-dividend fund and low price than a high-dividend fund at a high price. You never know when you will need the money, and it is better to redeem the fund at a profit.
Master Taxable Versus Nontaxable Funds
Put the highest-yielding investments in a nontaxable account such as an IRA and put the lowest-yielding investments in a taxable account.
Municipal bond funds are not subject to federal income taxes, so they work best in a taxable account.
Likewise, Master Limited Partnerships also work best in taxable accounts.
The IRS gives special treatment to qualified dividends. They have a tax rate ranging from 0% to 23.8% depending on a person's income.
The income investor must hold the stock for at least 60 days and invest it in a U.S. company or foreign company with special ties to the U.S.
Early Years: Reinvest All Dividends
An income investment strategy works best when all dividends buy more investments. Those reinvested dividends produce more income, which reinvested will grow the income even more at a compound rate.
Financial security grows when the amount of monthly and yearly income reach the point of being able to cover core family expenses if necessary.
A small step arrives with the ability to cover utility bills each month, then groceries, then mortgages and so forth.
Getting to those points requires reinvesting the dividends and not using them for non-essential items.
Later Years: Invest Gains, Live on Dividends
Retirement or a job loss will not create financial insecurity if the income portfolio is large enough.
An investor may want to maintain the size of the portfolio but also use dividends for the sake of financial security or to increase the quality of life.
When stocks and bonds are sold at a profit, they generate capital gains. An investor may find the best of both worlds by re-investing the capital gains and living on the dividends.
Ideally, the capital gains (or growth in total value of the portfolio) will exceed the rate of inflation.
Income + Value = Growth
Portfolios grow from dividends, price increases and realized capital gains (the profit made from selling the investment).
An investor who consistently buys stable income at a good price consistently will see a portfolio grow consistently over the years and even decades ahead.
The money doesn’t seem like much in the early years. But 20 years later, if that company division is shutting down and people are losing their jobs, having a portfolio that can generate thousands of dollars every month will feel like a godsend.
Note: Nothing in this article is a recommendation to buy or sell a particular fund, stock or bond. The goal of the article is to encourage an income investing strategy.
© 2016 Scott Bateman
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